In many cases, you don't have to report a life insurance payout to the Internal Revenue Service at all. If, say, your partner had a $200,000 life insurance policy and you receive $200,000 at her death, that money isn't taxable. However, if the premiums the policy holder paid have earned enough interest over the years, the policy value may be higher. The excess value is taxable income.
Lump Sum or Installment
If the insurer pays you the money in a lump sum, figuring the taxes is simple. Just compare the death benefit to the face value of the policy; anything above the face value is taxable. Figuring the tax on installment payments also requires math. If, say, you receive the money in 100 monthly payments and the policy face value is $300,000, $3,000 out of each payment is tax free. Anything above that is not.
The extra value you receive is interest, so you report it on IRS Form 1040 as interest income rather than wages. The insurance company should send you a 1099-INT showing the amount of interest you received for the most recent tax year. The IRS gets another copy of this form, so don't send your 1099-INT in with your return. Use it to double-check the amount of interest, then save it in your records.
If you turn in your own life insurance policy early for the cash value, anything over the value of the premiums you've already paid counts as income. The insurer sends you a 1099-R form with the taxable amount on it. You report the money as pension/annuity income on your return. If you pay someone else for the right to collect on his policy -- a viatical settlement -- the IRS treats it differently. All the benefits in that situation are taxable.
Withholding and Benefits
Normally, neither the principal nor the interest on your insurance is subject to withholding. You get the whole amount and it's up to you to pay taxes on it. The big exception is backup withholding. If the IRS notifies you, repeatedly, that you've underreported interest or dividends on your return, and you don't respond, it can notify the insurer. The insurer then takes withholding out of the interest payments at a 28 percent rate. If you don't owe the IRS, you should state on the insurer's W-9 form that you're not subject to backup withholding.