The U.S. Income Tax Code is complex and confusing. In most cases, the income that you earn is taxed according to your total annual earnings. In theory, the country's tax laws are set up to favor workers with relatively low incomes over workers with relatively high incomes. Depending upon your annual earnings, your income will be taxed at one of several "marginal rates" each year. These rates can be changed by Congress and fluctuate on an occasional basis. Current tax rates for the top category of wage-earners are about 40 percent of total taxable income. For earners in the bottom bracket, this figure is about 10 percent.
Certain types of "unearned income" are not considered taxable. When you receive unearned income, you must claim it as part of your gross income on your tax return. However, it won't factor into the final calculation of your taxable income. In effect, the total amount of your unearned income will function as a deduction that may be applied to your gross income. Like a regular tax deduction, it will shrink the portion of your income that the federal government considers to be taxable.
"Unearned income" may include unemployment benefits and court settlements. In most cases, life insurance proceeds also fall into this category of income. You generally don't need to claim the income that you receive from a life insurance policy on which you're named as a beneficiary.
There is a notable exception to this general rule. A portion of the benefits that you receive through an employer-sponsored life insurance plan may be taxable under federal law. If you receive benefits from an employer-sponsored policy, you'll be able to claim at least $50,000 of these as unearned income. Beyond that amount, you'll have to pay taxes on any benefits that you receive. For instance, you'll need to pay taxes on 87.5 percent of the proceeds that you receive from an employer-sponsored plan that carries a death benefit of $500,000.
Before you assume that your life insurance benefits are not taxable, consult with your tax attorney or a tax preparation specialist. You should also check with your state's revenue service. In certain areas of the country, there may be state-level exceptions to the "unearned income" rule that governs life insurance proceeds. For instance, your earnings may be subject to your state's estate or inheritance taxes. The rates on these types of taxes can be quite high.