When it comes to taxes, there are few simple rules. Taxation of death benefits depends on many factors, as well as the nature of the taxes. In some cases, your life insurance proceeds can pass to the policy's beneficiary tax-free when you die. If you take care to handle the policy properly, no one has to write a check to the Internal Revenue Service.
Death benefits are not income, but interest is. If you name your niece as beneficiary of your $250,000 policy, she does not have to report the $250,000 as income because this is the value of the policy. If a period of time passes between your death and payment of the benefits, however, and if the policy earns interest, this portion of the proceeds is taxable. If your niece receives $251,000, the $1,000 is reportable as unearned income and she must pay income tax on it.
The situation is more complex if your beneficiary receives the benefits in installments rather than all at once, because interest typically accrues in this situation. Just as if she received a lump sum at some time after your death, the interest is subject to income tax, but it becomes more complicated to figure out just how much that interest is. The easiest way is to divide the total death benefit by the number of years it pays out. For example, if the $250,000 policy pays out over 10 years, your niece receives $25,000 tax-free each year. Anything she receives over and above this amount is interest and it's reportable.
Estate as Beneficiary
If your assets generate any income during the probate process, your estate must pay income tax as well. If you name your estate as beneficiary of your life insurance policy, the same income tax rules apply. Any interest earned must be reported on the estate income tax return. Unfortunately, the principal portion of the death benefits become taxable in this situation as well. Your estate owns the proceeds, so they're subject to estate tax. As of 2013, estate tax rates range from 41 to 55 percent on estates valued at over $1 million unless Congress acts to restore pre-2013 legislation.
If you own the policy, your policy's death benefits can generate an estate tax even if you don't name your estate as the beneficiary. As your asset, the policy's proceeds are included in your taxable estate, even if your estate isn't the payee. An exception exists if you name your spouse as the beneficiary – bequests to spouses are tax-free. Otherwise, if the proceeds push the total value of your estate over $1 million, the balance is taxable. You can avoid this by transferring ownership of the policy to someone else, but there's a catch. If you die within three years of doing so, the IRS will still include the death benefits as part of your estate. If someone else purchases the policy in the first place, this is not the case, but you can have no "incidents of ownership" relating to it. This typically means you can't pay the premiums and you can't have any power to change beneficiaries. You can't borrow against the policy or cash it in. The same rules apply if you transfer the policy to someone else – you must do so entirely, relinquishing all control over it.