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Many loopholes exist to allow high-net-worth individuals to avoid estate taxes. However, if any portion of your estate is subject to Federal and State estate taxes, your heirs could owe the IRS anywhere from 18% to 40% of the taxable amount (IRS Form 706 Table A). If your estate is largely illiquid (real estate, business assets, etc.) it could become a financial burden on your heirs … and at the worst possible time. 

Life insurance is one tool you can use to not only reduce your taxable estate value, but provide the liquidity your heirs need to pay any estate taxes. 

How do I know if I will owe estate taxes?

As of 2022, estates with a value of less than $12.06 million in value are exempt from federal estate taxes (IRS.gov). Any value over and above that threshold is subject to Federal estate tax. That threshold is likely to increase every year since it is indexed to inflation. It is important to note that each state has their own threshold for state estate taxes. 

Note that a talented estate tax attorney has many (perfectly legal) techniques at his disposal to shield larger estates from taxation.  

Can my beneficiaries use my life insurance to pay estate taxes?

Your beneficiaries can use your life insurance death benefit proceeds, as well as the liquid value of a cash value life insurance policy, any way they please. This includes settling estate taxes upon ones passing.  

Will my life insurance itself be taxable?

Under most circumstances, your life insurance death benefit is not taxable, either as part of your estate or as income for the beneficiary. 

However, the death benefit value of a life insurance policy will be included as part of the value of your estate for tax purposes … if you hold it in your name. 

How to prevent your life insurance from being included in your taxable estate

The easiest way to prevent the value of your life insurance from being included in the taxable value of your estate is for someone else to own the insurance policy. This can be accomplished in a number of ways. 

Have the beneficiary buy a life insurance policy on your life

The law doesn’t stipulate that you are the only one who can purchase life insurance on your life. Other people can purchase life insurance on your life if two requirements are met: 

• You consent to the purchase.
• Your life has verifiable financial relevance for the purchaser, also known as insurable interest

If someone else owns the policy, it is not included in your taxable estate upon your passing. This also has the benefit of avoiding the Federal gift tax your heirs may face if you transfer an existing life policy to their name. 

Transfer your life insurance to another individual

If you have an existing life policy that you don’t want included in your taxable estate, one option is to transfer the ownership of the policy to another individual.  

Several rules apply to such transfers, however:

• The transfer must take place three years prior to your death for it to avoid inclusion in your taxable estate. If you pass away less than three years after the transfer, the value of the policy is retroactively included in your estate for tax purposes. In other words, sooner is better … but since death is unpredictable, there is some risk to choosing this method.
• Another rule requires you to transfer all power over the policy to the recipient. If you retain the power to name or change beneficiaries to the policy, borrow against the policy, select the payment method, or cancel the policy, these are considered “incidents of ownership.” If you retain any incidents of ownership, you are still considered the owner and it will be included in your taxable estate. The bottom line — you have to trust the person you transfer the policy to.
• Additionally, the transfer of life insurance is considered a gift, and thus subject to Federal and State gift tax rules. Talk to your accountant about whether or not your heirs will be in a better position with this gift tax vs. estate tax.

Transfer your life insurance to an irrevocable life insurance trust (ILIT)

An irrevocable life insurance trust is an entity set up for the purpose of holding “and controlling” the life insurance policy. If you transfer your policy to such a trust, you no longer “own” it — the trust does. However, in the drafting of the trust document, you are able to set parameters as to who and how you want the beneficiaries of the trust to benefit.

For a life insurance trust to remove your policy from your taxable estate, it must meet several requirements:

• The trust must be irrevocable.
• You cannot be the trustee.
• The trust must be established three years before your death. Again, sooner is better.

Complex tax rules apply to irrevocable life insurance trusts. Make sure to consult with your attorney and tax specialist about the implications of this method.

Using life insurance to pay estate taxes can help reduce the financial burden of your death for your loved ones. With the right strategy, it is a powerful tool to create an even bigger financial legacy for your successors.