7.4 Life Insurance Transfer-for-Value Rule

The transfer-for-value rule was enacted by Congress to prevent individuals or businesses from transferring ownership of life insurance policies simply to benefit from the tax-free nature of death benefit proceeds.

Under this rule, if a life insurance policy is transferred to a new owner in exchange for valuable consideration, the death benefit may lose part of its tax-exempt status. Specifically, any portion of the death benefit that exceeds the amount paid for the policy plus any additional premiums paid by the new owner will be taxed as ordinary income.

However, if the transfer meets one of the permitted exceptions to the rule, the death benefit may still be received entirely income tax free.

Example

Assume a $500,000 life insurance policy is sold to a new owner for $50,000. After purchasing the policy, the new owner pays an additional $10,000 in premiums while the insured remains alive.

At the insured's death, the beneficiary receives:

• $60,000 tax free (the purchase price plus premiums paid: $50,000 + $10,000)
• $440,000 taxable as ordinary income ($500,000 − $60,000)