What happens to life insurance proceeds if the beneficiary opts for an annuity payment?

When a beneficiary opts for an annuity payment as a way to receive life insurance proceeds, it means that instead of taking the entire sum upfront, the cash benefit is distributed over time in scheduled payments. In this arrangement, the principal amount of the life insurance proceeds remains tax-free as it is part of the insurance benefit. However, any earnings generated from the investment of these proceeds through the annuity, such as interest or gains accrued over the payment period, are subject to taxation.

The nature of annuities allows beneficiaries to spread out their proceeds over a longer period, which can lead to interest income. This income is taxable, which is an important aspect to consider, especially for beneficiaries who might prefer to maximize their tax efficiency when receiving these payments. Thus, the correct choice reflects the tax implications associated with the interest earned on the amount received through the annuity option.