In all ordinary situations the death benefit from a life insurance policy is income tax free. Be sure to note that all death benefits received are income tax free – meaning that they can still have estate tax (death tax) and transfer tax ramifications (especially for larger dollar value estates).
The first sentence of this answer will be correct and is sufficient enough for 99.9% of everyone that receives a life insurance death benefit. However, just like everything tax related there are a few exceptions.
Your death benefit proceeds can become income taxable in two different situations:
(1) Your Policy is a Modified Endowment Contract (MEC) – a policy ceases to be a life insurance policy and becomes a MEC when the 7 pay test is violated. Your life insurance agent will be able to help you make sure that you do not run afoul of this test but what it really is designed to do is to prevent people from contributing too much money too fast to a life insurance contract and using the policy purely for investment purposes. If you stay within the 7 pay test guidelines then you will not have to worry about turning your life insurance policy into a Modified Endowment Contract.
(2) Your Policy Falls Under the “Transfer for Value” Rules – the transfer for value rules state that if a life insurance policy is sold, traded, bartered (transferred for valuable consideration) to anyone other than these 3 following groups of people then the death benefit loses its income tax free status. The 3 groups of people that are exceptions to the transfer for value rule (meaning that it is OK to transfer a policy to any of these 3 groups of people because the income tax free treatment of the death benefit will not change) include:
I. The Insured
II. A Partner or Shareholder of the Insured
III. A Partnership or Corporation where the Insured is a Partner or Shareholder/Officer.
Hope that this answers your question Peter! (This answer is only generalized information so be sure that you speak with a qualified tax professional about this any other tax and estate planning issues).
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SOURCE: IRS Publication 525, IRS Tax Topic 422, and IRS FAQ 4.9