Lump Sum

• The lump sum payment of a life insurance contract is not subject to income taxation. However, the death benefit may be included in your estate. When you pass this money on to your beneficiary, it's important for him to understand that estate taxes will be due on your estate. Unless the ownership is transferred to a life insurance trust or another individual -- i.e., a spouse or other family member you trust to take ownership of the policy during your life -- your policy death benefit will be added to the value of your estate when determining estate taxes. While the death benefit won't be taxable, your beneficiary may need to spend some of the death benefit to settle the estate.
  
  

Annuity Payments

• A life insurance death benefit may be paid out over time. If this happens, your beneficiary will be converting the death benefit to an annuity. The annuity payments will be stretched out over your beneficiary's lifetime. Part of the annuity -- approximately 95 percent or more -- will be considered a return of the death benefit, while the rest -- approximately 5 percent or less -- will be considered investment interest. The investment interest will be taxable.
  
  

Invested

• Your beneficiary can opt to leave the death benefit with the insurance company. If she does, the insurer will invest the money into the company's general account. The general account is made up primarily of bonds and bond-like investments. The bonds pay a fixed rate of return, which the insurance company pays to the beneficiary. Your beneficiary will have to pay income tax on all of the proceeds of the death benefit interest, even though the death benefit itself is exempt from taxation.
  
  

Expert Insight

• Even though your beneficiary may be subject to income tax on any interest income earned by the death benefit, the best option for death benefit payment may be payments over time. This is because there is less chance that the beneficiary will mishandle the funds and spend them too quickly. Unless there is an immediate need for a large lump sum, the annuity payment option may best suit your beneficiary. This is especially true if the beneficiary will need to depend on this money for income.
  
  Some life insurance companies even allow you to specify how death benefits are to be paid to your beneficiary so that the beneficiary receives the benefit according to your instructions.