Are you taxed on inherited life insurance money?

OK, you don't 'inherit' life insurance money. You are the beneficiary.

Under most circumstances, you do not pay taxes on money you receive as a beneficiary - but if the ESTATE receives the money, then the ESTATE is subject to taxes, before you INHERIT money from the estate.

Life Insurance Inheritance

If the life insurance policy names a person as the beneficiary, then those proceeds are not taxable to the person receiving them. If the life insurance names the estate as the beneficiary, and if the estate is valued at more than $3.5 million in 2009 there would be Federal Estate Tax due on the estate.

As long as you have named each other as beneficiaries then there is no tax. If you named your estate as the beneficiary, you may want to change your beneficiary designation. As some one already said, life insurance proceeds are not an "inheritance" in legal terms. In legal terms it is a "benefit" so the person receiving it is the beneficiary.

mbrcatz doesn't understand the taxation of life insurance properly. The proceeds of a life insurance policy ALWAYS are calculated as an asset in the owner's estate and would be subject to estate taxes. If you die this year then your estate is exempt from the first $3.5 million so for most people they wouldn't pay any tax.

So, it does not matter whether it's paid back to the estate or directly to the beneficiary for estate tax purposes. BUT, it is still foolish to pay to an estate because then it does become subject to probate costs.

In your example neither one of you would pay any tax at all.

It's because the life insurance was an annuity, which is an investment account. Any taxes on the account have been deferred (held) until the death claim is paid. It becomes taxable to the beneficiary (you). The 1099-INT is interest on the account The 1099-R received represents taxable gain in the policy (the money was in an investment and grew in value)

Life insurance benefits are not inherited. They are paid directly to the beneficiary by the insurer and are not taxable income.

The beneficiary of life insurance does not pay any tax on it. It is considered part of the gross estate of the deceased for estate tax purposes if the deceased had any control over the policy at all [even if just to name beneficiary(s)]. However, anything that goes to the spouse is deducted from the gross estate before figuring any tax.