Normally, life insurance policy payments are free of federal income tax. However, federal estate tax is a different case. A recent SmartMoney article discussed how policy beneficiaries can avoid paying federal estate tax for their payments.
If life insurance payments are set to go directly to a beneficiary that is a non-spouse, such as a child or sibling, the payments are included within one's taxable estate. If the payments are going to a surviving spouse - and the person is a legal U.S. citizen - the payments are also included within a taxable estate. Furthermore, if one has life insurance coverage that exceeds an estate of $5 million, the payments are taxed.
The article describes how to avoid these scenarios, however. Those that want to avoid tax hits due to policy payments should set up an irrevocable life insurance trust to own the policy. The trust is then responsible for the premiums, and the payments from the policy are paid out to whoever is listed as the beneficiary. Under this scenario, the policy is not a victim of federal estate tax nor federal income tax.
This scenario does present some complexities, so SmartMoney suggests hiring a professional to sort out the technicalities.