Understanding Estate Taxes
Estate taxes apply to the value of a person’s estate at death. The tax amount depends on the size of the estate and the federal or state rules in effect. It generally affects estates that exceed specific exemption limits.
What Is Included in an Estate
Estate taxes are based on the total value of assets at death, which may include:
- Cash
- Real estate
- Investments
- Business interests
- Personal property
Federal and State Estate Taxes
The federal estate tax exemption can change over time. For 2026, the federal exemption is $15 million. Some states impose their own estate or inheritance taxes, often with much lower exemption limits than the federal threshold.1
Why Estate Taxes Matter
Estate taxes can significantly reduce what heirs receive. If an estate exceeds federal or state exemption amounts, heirs may face large tax bills. In some cases, this may require selling assets, such as real estate or business interests, to cover the tax obligation.
For many families, the concern is that valuable assets could be lost simply to pay estate taxes.
How Life Insurance Helps with Estate Taxes
Life insurance is a powerful tool that can help reduce the impact of estate taxes. The death benefit is generally paid tax-free and can be used to cover estate tax costs. This helps beneficiaries avoid selling assets to meet tax obligation.
Provides Liquidity
After a death, many assets must go through probate, which can delay access to funds.
Estate taxes are often due before assets can be easily converted to cash. If an estate lacks liquidity, heirs may need to sell property, investments, or a family business quickly, sometimes at a loss.
Life insurance provides immediate cash through the death benefit. This money can be used to pay estate taxes and other obligations without disrupting long-term assets.
Example assets that are often hard to sell quickly:
- Real estate
- Family-owned businesses
- Long-term investments
Life insurance can help preserve these assets by covering tax-related costs upfront.
Tax-Free Death Benefits
Life insurance death benefits are generally paid income tax-free to beneficiaries. This allows the full benefit amount to be used for estate taxes or related expenses without being reduced by income taxes.
Irrevocable Life Insurance Trust (ILIT)
An irrevocable life insurance trust, or ILIT, is a commonly used estate planning tool to help keep life insurance proceeds out of a taxable estate.
When the trust owns the policy:
- The death benefit is not included in the estate
- The proceeds are not subject to estate taxes
- More value can be passed to beneficiaries
Creating an ILIT removes policy ownership from your estate and helps ensure the proceeds are available to heirs without increasing the estate’s taxable value.
If estate taxes are a concern, a qualified financial advisor or estate planning attorney can help review options and determine whether an irrevocable trust may be appropriate for your situation.
Benefits of Using Life Insurance for Estate Taxes
Life insurance can play a practical role in covering estate taxes while helping preserve how assets are passed on to heirs. Here are the main benefits of using life insurance to help pay estate taxes and support your estate strategy:
- Helping Protect the Value of Your Estate: Life insurance can provide funds to help pay estate taxes. This can reduce the need to sell property, investments, or family-owned assets so heirs can receive more of the estate as intended.
- Maintaining Privacy and Control: When an estate lacks enough liquidity, taxes can create delays and added complexity. Life insurance allows you to decide which assets stay in the family. Proceeds are paid directly to beneficiaries and typically bypass probate, keeping financial details private.
- Simplifying the Estate Settlement Process: Estate settlement often involves tight timelines for tax payments. Life insurance can provide immediate cash to help cover these obligations, which can make the process easier for heirs to manage.
Steps to Include Life Insurance in Estate Planning
Incorporating ownership of life insurance into estate planning involves a series of steps to help ensure it aligns with your overall financial goals.
1. Evaluate Your Estate’s Needs
Assess your estate's size and estimate potential estate tax liability to determine tax obligations and necessary liquidity.
2. Choose the Right Type of Life Insurance Policy
When it comes to estate planning, choosing the right policy for estate protection is crucial. Different types of life insurance can serve estate planning needs. There are two primary types to consider: term life insurance and permanent life insurance.
| Feature | Term Life Insurance | Permanent Life Insurance |
|---|---|---|
| Coverage Duration | 10, 20, or 30 years | Lifetime coverage |
| Premiums | Typically lower | Higher but consistent |
| Cash Value Accumulation | None | Accumulates cash value |
| Ideal for Estate Tax Planning | Not ideal, as it may expire before death | Preferred for guaranteed death benefit |
| Affordability | More affordable in the short-term | More costly but provides lifelong security |
| Use for Estate Taxes | Limited, only if death occurs during the term | Effective for covering estate tax liabilities |
Permanent life policies, like whole life or universal life insurance, are commonly used for estate planning. They offer lifelong coverage and accumulate cash value, which is helpful for estate taxes.
3. Consider Setting Up an ILIT
To help ensure that life insurance proceeds are not included in your estate’s taxable value, consider setting up an irrevocable life insurance trust (ILIT). With an ILIT, the policy is owned by the trust, and the death benefit can be used to pay estate taxes or other expenses without adding to the taxable estate.
4. Work with Financial and Legal Professionals
Estate planning can be complex, especially when dealing with tax laws and large estates. It is important to consult with financial professionals, estate attorneys, and tax professionals to create a strategy that works best for your unique circumstances and estate planning goals.
These professionals can help determine the right policy type, appropriate ownership structure, the use of trusts, and provide legal advice.
Common Misconceptions
Several misconceptions regarding life insurance and estate tax planning need to be addressed.
Life Insurance Is Always Free From Estate Taxes
Life insurance proceeds are generally income tax-free, but they may still be included in your taxable estate if you own the policy at death. To exclude the death benefit from your estate, ownership must be transferred or the policy must be owned by an irrevocable life insurance trust.
Estate Taxes Only Affect the Ultra-Wealthy
Estate taxes are not limited to the ultra-wealthy. State estate tax exemptions are often much lower than the federal threshold. Even if an estate is not subject to federal estate taxes, it may still face state-level taxes, which affects a broader range of individuals.
Term Life Insurance Is Sufficient for Estate Planning
Term life insurance is often viewed as a sufficient option due to lower premiums. However, because coverage lasts for a set period, it may not align with estate tax timing. Permanent life insurance offers a guaranteed death benefit, which can better support estate tax obligations.
Case Study: Life Insurance in Action
Consider the case of a family that owns a substantial amount of real estate. Upon the death of the family patriarch, the estate faces millions in estate taxes.
Rather than selling off a cherished family property to cover the taxes due to lack of estate liquidity, the family utilizes the proceeds from a life insurance policy to meet their outstanding debts.
By having the insurance proceeds available, the family retains the property, allowing them to continue benefiting from its value and significance.
In this example, the foresight to incorporate life insurance into estate planning avoided the forced liquidation of assets, ultimately preserving the family’s legacy.
Conclusion
Estate taxes don’t have to overshadow your legacy. Integrating life insurance into your estate plan can help ensure your loved ones inherit assets with less tax impact while providing liquidity to cover taxes and expenses without selling property. It can also support a more tax-efficient transfer of wealth to future generations, so talk with a financial professional to create a strategy that fits your needs.
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Sources
- Estate Tax - U.S. Internal Revenue Service (IRS). https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
