Before getting to the contractual aspects of life insurance contracts, let's first explore the highly tax-favored status of life insurance. As we saw in our earlier tax analysis, generally whenever there is an increase in our recognized wealth, there is a corresponding increase in our Gross Income (see Exhibit 1 on Page 9). One of the few exceptions to this rule is that death proceeds from life insurance contracts are income tax-free to the recipient (beneficiary) of those life insurance proceeds.
Example: Mark maintained $400,000 of life insurance on his life through the purchase of cheaper Term life insurance contracts (described below). His wife, Debbie, is the named beneficiary under those contracts. Mark predeceases Debbie and the life insurance company makes a lump‑sum payment to her of $400,000. After dancing on his grave, Debbie invests the $400,000 in various forms of investments to provide income. The $400,000 payment to Debbie is totally income tax-free to her. Income generated from the $400,000 of principal, however, will be subject to normal income taxation.
There is also an income tax deferral benefit with regard to life insurance contracts within which there is a cash value element. Cash value life insurance policies are described in detail below.