For estates exceeding the $15 million federal exemption threshold, life insurance can provide liquidity to pay the 40% estate tax without forcing the sale of illiquid business or real estate holdings. The death benefits are generally income-tax-free under IRC §101(a) and, if structured correctly, can be excluded from the taxable estate.
For example, if an individual with an estate exceeding the exemption limit purchases a $2 million life insurance policy with a single premium payment of $500,000, they must fund the purchase through an Irrevocable Life Insurance Trust (ILIT). Because the $500,000 transfer is a completed gift to the ILIT, it reduces the taxable estate. At a 40% estate tax rate, removing $500,000 from the estate saves $200,000 in future estate taxes. The net cash outflow from the estate is $300,000, while the heirs receive a $2 million tax-free payout, representing a significant net gain.
This strategy requires using an ILIT as the policy owner and beneficiary. If you transfer an existing policy to the trust, the proceeds will be pulled back into your estate if you die within three years of the transfer under the three-year rule of IRC §2035, “Adjustments for certain gifts made within 3 years of decedent’s death”. To avoid this, the trustee should apply for and purchase the policy from the outset.
An ILIT also provides asset protection by shielding the policy proceeds from the beneficiaries’ creditors, maintains family privacy by keeping the distribution out of probate court, and prevents the proceeds from inflating the survivor’s taxable estate. However, the trust is irrevocable: once established, you cannot amend the terms or reclaim the policy. You must also evaluate the insurer’s financial strength using ratings from agencies such as A.M. Best, Moody’s, or Standard & Poor’s, and ensure premiums are funded consistently to keep the policy in force.
For further reading, see the analysis in Why the Wealthy Should Consider Buying Life Insurance.