If someone dies and you're her life insurance beneficiary, you may have to pay taxes on the money. When you cash in your own policy or collect dividends on the premium, that money is often taxable too. In other cases, there's no tax and you can collect the cash without owing the IRS.
Cashing It In
When you take out a cash-value life insurance policy, interest on your premiums accumulates tax-free. If you decide to cash the policy in, or sell it to someone else, you pay income tax on your profits -- whatever money you received less the total you've paid in premiums. Likewise, if the policy pays dividends, they become taxable as soon as you make more in dividends than you've paid the insurer.
When you're the beneficiary and you receive the face value of the policy as a death benefit, there's no tax due. If interest on the premiums gives you more than face value, the excess is taxable. If it's a lump-sum payment, you pay tax on the benefits all at once. If you take your money in installments, divide the number of payments into the face value. Whatever part of the payments is more than that is what you pay tax on.
The value of the policy counts as an asset of the owner's estate. If the estate is large enough to pay estate tax, the value is taxable. This isn't an issue for most people: It takes an estate of at least $1 million to trigger the tax. If the beneficiary is the policyholder's spouse, there's even less of an issue. Anything one spouse leaves to the other is exempt from tax. If tax is due, it's the estate -- not the beneficiary -- that pays.
If the policyholder knows her estate is big enough to pay tax, she can transfer ownership of the policy to you. This removes it from her estate, and therefore from estate-tax calculations. You then have to pay the premiums, but the former policyholder can give you up to $13,000 a year for premiums without triggering any gift-tax payments. Transferring the policy to a trust is another way around the tax.