When is the payment of life insurance policy proceeds considered taxable?

The payment of life insurance policy proceeds is considered taxable when taken as an annuity with accrued interest. This is because the principal amount of the life insurance benefit is generally not subject to income tax; however, any interest or earnings that accumulate on that benefit when it is paid out as an annuity are subject to taxation. This means that if an individual opts to receive the policy proceeds in a way that allows for the growth of interest over time, that growth is taxed as ordinary income.

In contrast, if the policy proceeds are cashed in immediately or transferred to an exempt beneficiary, there are typically no taxes applied to those amounts. Tax considerations are different for surviving beyond the policy term, as the death benefit is not impacted by how long the policyholder lives, only the timing of its disbursement and how it's administered can affect tax implications. Thus, when considering the contexts of tax obligations, the annuity option represents a scenario where taxable interest income arises.