How Life Insurance Relates to Estate Tax

Life insurance and estate tax have a complex relationship that is frequently misunderstood. While the death benefit is income-tax-free to beneficiaries under IRC Section 101(a), it is not automatically estate-tax-free. If the insured owned the policy at death or had "incidents of ownership" within three years of death, the full death benefit is included in the insured's taxable estate for federal estate tax purposes. This distinction between income tax treatment and estate tax treatment is one of the most important concepts in life insurance-based estate planning.

Incidents of ownership include the right to change beneficiaries, the right to borrow against the policy, the right to surrender the policy, the right to assign the policy, and the right to change premium payment methods. Essentially, if you have any control over the policy, you have incidents of ownership. Even seemingly minor rights — such as the right to change the timing of premium payments — can constitute incidents of ownership that pull the death benefit into the taxable estate.

For estates above the federal estate tax exemption (currently $13.61 million per individual, though this amount is scheduled to decrease significantly in 2026 if current legislation sunsets), the inclusion of a large life insurance death benefit can push the estate over the threshold and trigger estate taxes at rates up to 40%. For a married couple, the combined exemption is approximately $27.22 million under current law. These exemption amounts are indexed for inflation and subject to legislative change.

The primary strategy for excluding life insurance from the taxable estate is to use an Irrevocable Life Insurance Trust (ILIT). The ILIT owns the policy, pays premiums (funded by the grantor's gifts to the trust), and distributes the death benefit according to the trust terms. Because the insured never owns the policy, the death benefit is not included in their taxable estate. This strategy is the cornerstone of life insurance-based estate planning for affluent families.

For existing policies, transferring ownership to an ILIT is possible but triggers a three-year lookback rule — if the insured dies within three years of the transfer, the death benefit is pulled back into the estate under IRC Section 2035. This is why proactive planning, ideally having the ILIT purchase the policy from the start, is the preferred approach. The three-year lookback creates a planning window during which the strategy is vulnerable, making early action important.

Second-to-die (survivorship) policies are another estate planning tool. These policies insure two lives (typically spouses) and pay the death benefit only when the second insured dies. Since the federal estate tax on the first spouse's death is typically deferred through the marital deduction, a second-to-die policy provides the death benefit exactly when the estate tax becomes due — at the second death. Combined with ILIT ownership, survivorship policies provide tax-efficient estate liquidity.

The estate tax landscape is subject to legislative change. The current elevated exemptions under the Tax Cuts and Jobs Act of 2017 are scheduled to sunset after 2025, potentially reducing the exemption by roughly half. This potential change makes estate planning with life insurance more urgent for families with estates that may be affected by lower exemptions. Even families whose estates are currently below the exemption threshold may want to plan for the possibility of lower thresholds in the future.

Estate planning involving life insurance requires coordination between an estate planning attorney, a tax advisor, and a licensed insurance agent. The legal structure of the trust, the tax implications of the gifting strategy, and the insurance product selection must all work together to achieve the desired outcome. Agents in our network can coordinate with Tennessee estate planning attorneys to structure ILIT-owned policies.