YOU ASK:

Do I need to pay federal income tax on life insurance proceeds?

WE ANSWER:

Whether you owe any federal income tax on a life insurance policy death benefit will depend primarily on your relation to the insured.

If you can prove that you have had insurable interest in the insured's life, you will receive the life insurance proceeds income-tax free. Conversely, if you have been transferred the policy for commercial purposes, you owe income tax on the interest part of the proceeds.

When is the Death Benefit Income-Tax Free?

In situations when life insurance proceeds are paid to a designated beneficiary in a lump sum after the insured's death, the proceeds are not subject to federal income taxation. This is regulated under Treasury Regulation 1.101-1: "Death proceeds from single premium, term life insurance, periodic premium or flexible premium life insurance policies, are received income tax free by the beneficiary regardless of whether the beneficiary is an individual, a corporation, a partnership, a trustee, or the insured's estate."

According to this tax regulation, death benefits are excluded from the beneficiary's gross income. The only condition for the proceeds to count as tax-free is that the beneficiary is designated by the policyholder.

When is Federal Income Tax Payable?

Where a life insurance policy has been sold from one policyholder to another and the beneficiary does not have an insurable interest in the insured's life, part of the death benefit is taxable.

When the death benefit is liquidated under a settlement option such as a viatical or a life settlement, the interest is subject to tax as ordinary income.

Under the so-called transfer for value rule, the part of the death benefit, which exceeds the aggregate of the purchase, becomes taxable when the insured dies. However, if the policy is transferred to a person with an insurable interest in the insured's life, such as the partner or the children of the insured, the policy proceeds retain their income tax-free status.

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