A. No Federal income tax is due for life insurance benefits. However, the death benefit is still part of the estate and will be subject to estate tax. While the Federal estate tax threshold is $5M+ per person, many states also have estate tax with lower thresholds.
There are two ways to exclude life insurance payment from the estate calculation:
1) Transfer the life insurance ownership to another person.
Such transfer of life policy ownership is irrevocable, so make sure you carefully consider all aspects, especially the possibility of divorce.
2) Transfer the life policy to an Irrevocable Life Insurance Trust.
After the transfer, you are no longer the owner of the policy. Compared with the first method mentioned above, this method allows you a little more "control" of the policy. For example, you don't have to worry the new owner will stop paying the premium of the life policy; you are also able to designate trustee of the trust.
Before you using any of the above two methods, there is one thing very important to note:
IRS has a 3-year rule - if you die within 3 years of the transfer of ownership, you are still viewed as the owner of the life policy, therefore the benefit payment is still counted as part of your estate.