If you're named as the beneficiary on a life insurance policy, you can look forward to a substantial payout at some point in the future. If the policy in question is a term life policy, the death benefit that you stand to receive will be identical to the policy's face value. In most cases, you'll receive this payout without incurring a tax liability. If the policy in question carried a face value of $250,000 and must issue its payout as a lump-sum payment, you'll receive a check for exactly $250,000 upon the death of the policyholder.
On the other hand, most life insurance beneficiaries choose to receive death benefits in the form of annuity payouts. This arrangement establishes a fund that uses the original death benefit as its principal amount. Every year, the life insurance company that oversees the disbursement of the policy's benefits issues a proportional payment from this fund. Each of these payments must include a portion of the fund's principal as well as a smaller sum of accrued interest. Depending upon the size of the principal and the rate at which it accrues interest, this sum can be fairly impressive.
If you elect to receive your death benefits as a series of annuity payments, you won't have to pay tax on any of the principal that you earn. However, you may need to pay tax on the interest that the principal accrues. Since the tax laws that govern the disbursement of life insurance proceeds are fairly complicated and may vary by state, you'll need to check with a tax preparation specialist about your annuity-related tax liability. In certain circumstances, you might be able to insulate yourself from any tax liability by creating a tax-protected retirement or college-savings account with your annuity payments. Your life insurance company may be able to make the necessary arrangements.
It's important to note that employer-sponsored term life insurance policies are subject to different tax laws. If you're the beneficiary on such a policy, you may need to pay taxes on a portion of its death benefit. According to current IRS regulations, employer-sponsored life insurance plans may issue death benefits of as much as $50,000 without incurring tax liabilities for their beneficiaries. Any death benefits that exceed this $50,000 cap must be taxed at the appropriate income tax rates. If you stand to receive a death benefit of $250,000 from an employer-sponsored life insurance plan, you'll need to count $200,000 as taxable income.