As noted in the section concerning trust funds, families sometimes will ask for an asset to be disregarded if it represents the proceeds of a life insurance policy on the deceased spouse. The usual reasoning is that the asset's earnings represents a replacement for the income from the deceased spouse.

If the life insurance policy premiums were paid with after-tax dollars, the proceeds of the life insurance policy represent untaxed income. If the payout is for a viatical settlement or an accelerated death benefit, it may be taxable income. A viatical settlement is not taxed if the insured is chronically or terminally ill, otherwise it is taxed.

The following discussion assumes that the payout is in the form of a lump sum, not an annuity, since the value of an annuity would be ignored as an asset by need analysis. Only the annual payment from an annuity would count as untaxed income on worksheet B.

Many financial aid administrators will not make an adjustment to the asset, because the funds are available to the family to use for any purpose. Some indicated that they would make an adjustment to the asset if the surviving parent does not have the ability to earn a living on his or her own. Some indicated that they would make an adjustment to the asset if the money were used to buy an annuity that was placed in an irrevocable trust. No financial aid administrators would make an adjustment to income.

In the event of a recent death, it is worthwhile to see whether the surviving spouse would have been required to file a 1040 during the prior tax year without the deceased spouse's income. If not, then the financial aid administrator can use professional judgment to use award year income for the surviving spouse. If the surviving spouse's income is below the threshold for the simplified needs test, the asset would be disregarded as a result.