When thinking of how life insurance proceeds are taxed, we're really thinking of two different scenarios: income tax and estate tax. Generally speaking, these two scenarios are at opposite ends of the tax spectrum in most instances.
Income Tax to the Beneficiary
As a general rule, life insurance benefits that are paid to a beneficiary in a lump sum are not included as income to the beneficiary. However, if the policy is combined with a non-refund life annuity contract where a single premium is equal to the face value of the insurance is paid, the the exclusion from income tax does not apply. The additional interest received above the face amount of the policy is taxable.
Life insurance policies that are owned by the decedent (the person who died) are included as part of his (or her) taxable estate for calculation of estate taxes. This would normally subject the estate to a tax burden, not necessarily the beneficiary of the policy. The only way to avoid the inclusion of the policy in the decedent's taxable estate is to assign the policy to a different individual (or trust). However, the assignment is subject to a three-year look back by the IRS. If the decedent dies within three years of the assignment, the IRS will still consider the policy to be owned by the decedent for estate tax purposes.
Paul A. Yokabitus