Do I owe tax on life insurance death benefits?

In general, life insurance death benefits are federal income tax-free since they are by law excluded from the beneficiary's income. However, this rule only applies to situations where the beneficiary has been designated by the policyholder.

When Do You Owe Federal Income Tax

In the case of a viatical or a life settlement, for example, where life insurance policies are sold from one policy owner to another, the life insurance proceeds are subject to taxation. Under the transfer for value rule, the part of the death benefit, which exceeds the total of the purchase price plus any premiums paid, loses its income-tax-free status when the insured dies.

To put it in a nutshell, if an existing life policy is transferred for the monetary value, all or part of the proceeds become taxable.

There are certain transfers that are exempt from the transfer for value rule. These are the transfers to people who have insurable interest in the insured's life, such as transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder.

Federal Estate Tax Exemptions

Even if the death benefit stays in the family, the life insurance policy proceeds might or might not be subject to estate tax depending on what your gross estate is.

In order to calculate your tentative estate tax, you need to subtract all your expenses from your assets. It is usually a good idea to hire an estate planner to do the calculations for you. However, nowadays fewer and fewer people end up paying estate tax because of the favorable tax policy in recent years: for 2009, for instance, only households with a gross estate of $3,500,000 were subject to estate tax, and in 2010 this type of tax is expected to be repealed by the Congress.