We buy life insurance to protect the ones we love when we die. We want to be sure that they will have money to live on, put kids through college, pay off the mortgage and generally live a comfortable life after we are gone. But what about the IRS, will they show up at our loved one’s door asking for money when we are gone?

The short answer is no, there are no taxes on life insurance. Whether the insurance benefit is paid out in a lump sum, or in installments over a period of time, it does not have to be reported on your tax return. However, if the insurance benefit received is greater than the amount of life insurance death benefit at the time of the insured’s death, that amount must be reported as taxable interest. What does this mean? Let’s look at an example.

Let’s say that you are the beneficiary of a life insurance policy for $500,000. Should you receive an amount of $500,000 either in a lump sum or over a period of time, say $50,000 for ten years, there is no need to report this as taxable interest income. End of story.

However, let’s say that the money was invested and earned income during the installment period when it was being paid to you. Then that interest income would be taxable and must be reported. Returning to our example, let’s say that you are to receive ten equal payments of $50,000 over a ten year period. On year one, you get the first $50,000. There will be no tax. But the remaining $450,000 was invested in a money market fund let’s say, and you receive 3% interest on the next installment of $50,000. So instead of $50,000, you receive $51,500, the original $50,000 plus $1500 of interest. In this case, you will owe tax on the $1,500 of interest because it is an additional amount beyond what the original face value of the life insurance policy paid out. So this $1,500 must be reported as taxable interest income on your tax return.

Always remember that dealing with taxes and the IRS can sometimes be a tricky matter, so it is always best to consult a professional with details regarding your personal situation.