The death benefit from a life insurance policy issued on a life that has died is received tax-free by the beneficiary in most circumstances:
- Exempt policy: proceeds paid on death are excluded from the beneficiary's income under the ITA. No income tax is payable on the death benefit itself.
- Non-exempt policy: a deemed disposition occurs at death, and the policyholder's estate may realize income equal to the difference between the accumulating fund and the ACB; however, the death benefit flowing to the beneficiary is still generally excluded.
Interest earned after death: if the insurer holds the death benefit and pays interest to the beneficiary (e.g., under a settlement option), the interest is taxable income in the beneficiary's hands. Only the original death benefit capital is tax-free; interest on top of it is not.
Key point for the exam: the death benefit is tax-free -- but interest earned on proceeds after death is not.
Recall: A client's $500,000 life insurance policy pays out on death. The beneficiary receives $500,000 and leaves it with the insurer for six months, earning $5,000 in interest before withdrawing. How much is taxable?