What tax implications arise from gains in life insurance policies?

The correct understanding of tax implications from gains in life insurance policies must consider the nature of life insurance contracts in the context of tax law. Generally, the death benefit of a life insurance policy is exempt from income tax for the beneficiaries, which can sometimes lead to confusion regarding the treatment of gains during the policyholder's life.

When a policy is surrendered for cash value or upon certain taxable events, any gain is typically treated as ordinary income, not as capital gains. This means that the gain is taxed at the individual's regular income tax rate rather than the lower capital gains rate that applies to investments. Therefore, the correct answer, indicating that gains are taxed as ordinary income, accurately reflects how the Internal Revenue Code treats these situations. It highlights the importance of understanding that the tax treatment of life insurance gains differs from other types of investments, particularly as it relates to how policy proceeds are taxed when received or realized.