Under which condition would life insurance proceeds be taxable by the federal government?

Life insurance proceeds are generally not subject to federal income tax when received by the beneficiary upon the death of the insured. However, if the policy has been transferred for value, the tax implications change. "Transfer for value" refers to a situation where a life insurance policy is sold or transferred to another party in exchange for value, such as money or services. In this case, the proceeds of the life insurance policy become taxable income to the recipient, meaning they may need to pay income tax on the gain received from the policy when the insured dies.

This taxation occurs because the transfer for value can convert the policy into a taxable investment, undermining the intended tax-free treatment of life insurance benefits. Essentially, if the value received from the policy exceeds the amount paid for it, the excess is taxable to the new policy owner or beneficiary.

On the other hand, proceeds paid directly to the policy owner, collaterally assigned to a lender, or taken as a lump sum typically do not trigger tax liability, maintaining the general principle that life insurance benefits are not taxed when paid out after the insured's death.