The question as to whether or not life insurance money is taxable has many different facets to it. In other words, it is not a simple question to answer. When you talk about life insurance money, you should talk about the premiums paid in and the benefits paid out. Some life insurance policies are used to defer taxes while interest grows, while others are straightforward policies that only pay a death benefit.
Any money paid as a death benefit to a beneficiary is not subject to any federal or state income tax. There are no exemptions or surprises to this rule. If the owner of the life insurance policy at the time of death is the original owner and you are a beneficiary of that policy, then the money is distributed to you tax free. If the policy was sold or transferred to someone else, then there will be income tax implications based on how much the new owner paid into the policy before the insured passed away.
A whole life policy is one that has a death benefit and an investment portion. You can also borrow against the death benefit of your whole life policy while you are alive. If you borrow just the death benefit amount, then you can take that money without paying income tax on it. But if your policy allows you to borrow more than the death benefit, then any amount over the death benefit is taxable.
With a whole life policy, the death benefit does get paid without being taxed. In some instances, if you choose to take the death benefit in installments then there might be taxes on any interest that accrues. The investment side of the policy can grow with interest tax-deferred for as long as the money remains in the policy. If you try to withdraw that money while you are alive, then you will pay tax on that money. When your beneficiary is paid that money, there will be taxes due on the interest that has accrued.
Life insurance is a great way to create a financial legacy you can leave to your family after you pass away. Since most of the money distributed to a beneficiary as a death benefit is tax free, a life insurance policy becomes a way to leave your family a nest egg without any tax implications attached.