Which statement is INCORRECT regarding the federal income tax treatment of life insurance?

The correct choice states that the entire cash surrender value is taxable, and this is indeed an incorrect statement regarding the federal income tax treatment of life insurance. In fact, the cash surrender value of a life insurance policy is not fully taxable. Instead, the accumulated cash value grows on a tax-deferred basis, and the policyholder only pays taxes if they withdraw an amount greater than the total premiums paid into the policy.

When the policy is surrendered, the difference between the cash surrender value and the premiums paid is considered taxable income. If the payout is less than or equal to the premiums paid, then there would be no taxable event. Thus, it is essential to understand that only the gains beyond the total premiums are subject to taxation, making the statement that the entire cash surrender value is taxable clearly incorrect.

By recognizing this, policyholders can better manage their life insurance assets and understand potential tax implications associated with their policies.