With very rare exceptions, life insurance proceeds are never taxed as ordinary income. However, they will be taxable as part of an estate. However, with the current estate tax exemption at $5.43 million, most estates will never owe an estate tax at the federal level. You may have to check in whether in fact the state in which the decedent died has an estate or inheritance tax independent of the federal tax. I hope this helps and good luck.
As a beneficiary, life insurance proceeds are not included in your gross income, therefore, do not need to be reported and are not taxed. Since life insurance premiums are typically paid with after-tax dollars (money that has already been taxed), their proceeds are exempt from income tax.
However, life insurance proceeds are taxed if they are paid in installments instead of a lump sum (e.g. Minnesota Life Omega Builder has an option of installments or lump sum due to their living benefit features). The interest paid on the installments is taxed at ordinary income rates.
In regards to estate taxes, the death benefit is included in the deceased's estate (the exemption is $5.45 million per individual in 2016), so it may be subject to federal and state tax if not established under an Irrevocable Life Insurance Trust (ILIT) or if gifted and three years has not passed.
If you have any further questions, I'd be happy to help.
Generally, life insurance death benefits that are paid out to a beneficiary in lump sum are not included as income to the recipient of the life insurance payout. This tax-free exclusion also covers death benefits payment made under endowment contracts, worker's compensation insurance contracts, employer's group plans or accident and health insurance contracts.
If a policy is combined with a non-refund life annuity contract where a single premium is equal to the face value of the insurance is paid, then the exclusion does not apply. If the death benefit face value is $250,000 (for example), and the beneficiary elects to receive monthly payments instead of the lump sum amount, the additional interest received above the $250,000 face amount is taxable.
While life insurance death benefits are generally excluded from income tax to the beneficiary, they are included as part of the estate of the deceased if the deceased was the owner of the policy at the time of death. This inclusion as part of the estate may subject the benefit paid to estate taxes both at the federal and state levels. Estate inclusion can be avoided if the owner of the life insurance policy is someone other than the deceased, however; this assignment must have occurred more than three years prior to the date of death, or the IRS will still consider the deceased as the policy owner for estate tax purposes. (Learn how to cut your tax bill while building wealth in Cut Your Tax Bill With Permanent Life Insurance.)