Soft magnetic composites (SMC’s) are produced compacting iron powder coated with a thin insulator and then heat-treating the greens. In this study, to improve magnetic properties of SMC’s, formation of heat resistant MgO insulation layer on iron powder particles was examined. It was found that the MgO coating can be made by a dry process with two steps, i.e., oxidation of the iron particle surfaces and reduction of iron oxide by magnesium vapor. The SMC fabricated from the MgO-coated powder exhibits high resistivity even after heat treatment at 600, which leads to low iron losses comparable to those of the as-punched silicon-iron laminations. This can be ascribed to complete relief of stress introduced in the compaction process.