You don't usually pay taxes on insurance payouts. Insurance isn't income: it's reimbursement for something you've already lost. Life insurance is sometimes an exception. Most of the money should be tax-free, but part of it may be taxable. The deceased's estate may also have to pay tax on it.
Life insurance policies have a face value, such as $100,000, $200,000 or $1 million. When the insurer pays you the face value, it's tax-free. Many policies, however, give you more than the face value because of the interest the premiums earned over the years. If the insurer pays, say, $226,000 on a $200,000 face-value policy, the $26,000 is taxable. You report the $26,000 on your 1040, just like your other interest or dividend income.
If you collect your benefits in a lump-sum, figure out how much, if any, of the money is above the face value. That part is taxable. If the policy doesn't have a stated value, you report any payout that's more than the total value of the premiums. Taking payment in installments requires more math. If, for example, you're a beneficiary on a $200,000 policy and get 100 monthly payments, anything over $2,000 a month is interest, and therefore taxable.
If the deceased owned the policy and paid the premiums, it counts as part of his estate. That makes it potentially vulnerable to estate tax, but only if the estate was -- as of 2013 -- greater than $5.25 million. Smaller estates don't owe tax. If the deceased was your spouse, you don't have to worry. Whatever he leaves to you is free of estate tax, no matter how much it's worth.
When death approaches, a life insurance owner can choose to sell the policy to a "viatical service provider." The buyer can be any individual or company who meets the state laws for viatical services. The deal gives the owner money to make his last years bearable; when he dies, the buyer collects the policy payout. If you buy a policy from the owner, the proceeds from the policy are fully taxable once you receive the insurance check.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.