Per IRS Publication 525 Taxable and Nontaxable Income, starting on page 22:
Life Insurance Proceeds
Life insurance proceeds paid to you because of the death of the insured person aren't taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. However, interest income received as a result of life insurance proceeds may be taxable.
Proceeds not received in installments. If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person's death. If the benefit payable at death isn't specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.
Proceeds received in installments. If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.
To determine the excluded part, divide the amount held by the insurance company (generally, the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.
Example 25. The face amount of the policyis $75,000 and, as beneficiary, you choose toreceive 120 monthly installments of $1,000each. The excluded part of each installment is$625 ($75,000 รท 120), or $7,500 for an entireyear. The rest of each payment, $375 a month(or $4,500 for an entire year), is interest incometo you.
Installments for life. If, as the beneficiaryunder an insurance contract, you're entitled toreceive the proceeds in installments for the restof your life without a refund or period-certainguarantee, you figure the excluded part of eachinstallment by dividing the amount held by theinsurance company by your life expectancy. Ifthere is a refund or period-certain guarantee,the amount held by the insurance company forthis purpose is reduced by the actuarial value ofthe guarantee.
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