Colorado Life Producer License Practice Test

When a beneficiary receives both principal and interest payments, which portion is taxable?

1. Principal portion

2. Both portions are taxable

3. Interest portion only

4. Neither portion is taxable

The correct answer is: Interest portion only

When a beneficiary receives both principal and interest payments, the portion that is taxable is the interest portion only. This is because interest payments are considered income and are subject to income tax. In contrast, the principal represents the original amount of money invested or the face value of a life insurance policy, which is not subject to income tax when received by the beneficiary as a death benefit. To clarify further, beneficiaries typically do not owe taxes on the life insurance death benefit received, as this amount is generally exempt from income tax under the Internal Revenue Code. However, any interest earned on that amount while it is being held or if it is part of a settlement that includes interest payments will be taxable. Thus, the correct focus is on the nature of the payments: principal is a return of capital and is not taxed, while interest constitutes income and is subject to taxation.