How Life Insurance Is Used in Estate Planning
Life insurance in estate planning explained: how an ILIT keeps the death benefit out of your taxable estate, how second-to-die policies pay estate tax, the three-year rule, incidents of ownership, buy-sell funding and the transfer-for-value trap.
Life insurance in estate planning is mostly about one problem: cash. An estate can owe tax and settlement costs within months of a death, while its value sits in a business, real estate or art that cannot be sold quickly or at a good price. A death benefit arrives as cash, generally free of income tax, and with the right ownership it can also stay outside the taxable estate. This guide explains how life insurance in estate planning works, who should own the policy, how an irrevocable life insurance trust (ILIT) and a survivorship policy fit, what the three-year rule does, how business owners fund buy-sell agreements and where the sources disagree. It covers the United States, uses 2026 figures where the sources give them and comes from law firms, an insurer and software vendors that sell related products, which the text flags.
Quick Answer: How Is Life Insurance Used in Estate Planning?
- To create liquidity. Hall PC, a Minnesota law firm, says ILIT proceeds provide cash to pay estate tax so the business does not have to be sold.
- To keep the death benefit out of the estate. A policy the insured owns, or controls through incidents of ownership, is generally included in the taxable estate, according to Greenleaf Trust. An ILIT owns the policy instead.
- To cover the second death. MassMutual says survivorship (second-to-die) insurance pays after the second insured dies, when estate taxes and costs typically come due.
- To fund business agreements. Buy-sell agreements often use policies, but Beancount warns of the transfer-for-value rule.
- To avoid mistakes. A transfer into an ILIT within three years of death pulls the proceeds back into the estate.
Why Life Insurance in Estate Planning Starts With Liquidity
MassMutual, an insurer that markets these products, says survivorship proceeds can give heirs cash so they do not have to sell assets such as art, stocks or real estate at fire-sale prices. Its example is a $20 million estate in which a 40% tax on the $5 million above a $15 million exemption would cost heirs $2 million absent other planning. Hall PC makes the same point for family businesses: ILIT proceeds can pay the tax so the company stays intact.
The two figures behind that example are the 2026 federal numbers, which two sources confirm.
| 2026 figure | Amount | Source |
|---|---|---|
| Federal estate and gift tax exemption per person | $15 million | Hall PC, MassMutual |
| Combined exemption for a couple using portability | Up to $30 million | MassMutual |
| Top federal estate tax rate | 40% | MassMutual, Lawvex |
| Annual gift exclusion per recipient | $19,000 | Hall PC |
A conflict to note: Lawvex’s April 2026 article states the 2025 exemption as $13.99 million per individual and says it is “scheduled to roughly halve in 2026 unless Congress acts.” That is outdated, since Hall PC and MassMutual both give $15 million for 2026 under the One Big Beautiful Bill Act. Lawvex is promotional estate planning content, so its figures should be treated with care, and the exemption is the number to confirm with your attorney.
Because only estates above the exemption owe federal tax, many families have other reasons to use life insurance, such as state estate taxes and business buyouts.
How Life Insurance Proceeds Are Taxed
Two rules apply, and they are often confused.
| Question | Rule | Source |
|---|---|---|
| Income tax on the death benefit | Generally income-tax-free to the beneficiary | Tamburro Law, MassMutual |
| Estate tax on the death benefit | Included in the taxable estate if payable to the estate, or if the insured held any incidents of ownership at death | Tamburro Law, Greenleaf Trust |
| Probate | Naming “payable to my estate” also subjects the proceeds to probate | Tamburro Law |
Greenleaf Trust, a trust company, lists what counts as an incident of ownership: the right to change the beneficiary, surrender or cancel the policy, assign or revoke an assignment, or borrow against or pledge the policy. If you have any of them at death, “the full death benefit will be included in the individual’s taxable estate.” Its first example involves a buy-sell agreement in which Ruth owned a $1.0 million policy on Rex’s life, but Rex had the right to borrow against it. Because Rex held that right at death, the full $1.0 million was included in his gross estate. When Rex released the borrowing right but died within three years, the proceeds were still taxed in his estate.
The Irrevocable Life Insurance Trust (ILIT)
An ILIT is the standard way to keep a policy outside the taxable estate. Lawvex, Hall PC and Tamburro Law describe the same mechanics.
| Feature | How it works |
|---|---|
| Ownership | The trust, not the individual, owns the policy, so the death benefit is generally excluded from the taxable estate (Lawvex) |
| Control | The trust is irrevocable, so the grantor gives up control, including changing beneficiaries or accessing cash value (Lawvex) |
| Trustee | A trustee other than the grantor administers the trust, and the insured cannot be the trustee or retain the right to revoke it (Lawvex, Tamburro Law) |
| Premiums | The grantor makes annual gifts so the trustee can pay premiums (Lawvex) |
| Payout | At death the insurer pays the trust, and the trustee distributes under the trust’s terms (Lawvex) |
| Benefit for beneficiaries | Trusts can help ensure premiums are paid and can manage proceeds for minors or beneficiaries who should receive funds over time (Tamburro Law) |
Crummey Powers and Annual Gifts
Gifts to an irrevocable trust are gifts of a “future interest,” which do not qualify for the annual exclusion. Lawvex explains that Crummey powers, named after Crummey v. Commissioner (1968), convert them into present interests. The trustee must send each beneficiary written notice of every contribution, typically giving 30 to 60 days to withdraw, and missed or improper notices can cause contributions to be treated as taxable gifts. Lawvex also says “hanging” withdrawal rights can limit lapsed amounts to the greater of $5,000 or 5% of trust assets per year.
The Three-Year Rule
Under IRC section 2035, if an existing policy is transferred into an ILIT and the insured dies within three years, the death benefit is included in the estate, Lawvex explains. Tamburro Law agrees that gifts of policies, including establishing an ILIT, made within three years of death are still included. There are two ways around it:
- Have the ILIT buy a new policy from the outset.
- Transfer an existing policy and survive three years, perhaps covering the gap with a term policy, as some planners do (Lawvex).
Greenleaf adds that releasing an incident of ownership within three years of death does not remove the policy from the estate either.
What an ILIT Costs
Lawvex gives attorney drafting fees of $2,000 to $7,000, depending on complexity, professional trustee fees of about 0.5% to 1.5% of trust assets a year and ongoing administration such as annual trust tax returns, Crummey notices and recordkeeping. Premiums vary by age, health, coverage and policy type. The firm suggests considering an ILIT when coverage is $1 million or more and says the estate tax savings on a $2 million policy could exceed $800,000 if the estate is taxable, a figure from a firm selling the service. Savings of that size apply only if the estate is taxable, and the article’s own exemption figures are outdated.
Survivorship (Second-to-Die) Insurance
MassMutual describes survivorship insurance as a policy that covers two people and pays after the second dies, usually sold as whole life, universal life or variable universal life. It says the policy was introduced in the early 1980s, after a tax law change let couples defer estate taxes until the last spouse died.
| Feature | What MassMutual says |
|---|---|
| Timing | Pays after the second death, when estate taxes and administrative costs typically come due |
| Cost advantage | Typically offers a larger death benefit for the same premium than two individual policies, since it pays only at the second death |
| Tax | Proceeds generally income-tax-free; they pass directly to beneficiaries and avoid probate |
| Other uses | Legacy goals, couples where one spouse has a medical condition, special needs trusts and business succession |
| Caveats | The death benefit must be large enough to cover what is owed, and the policy must still be in force when the second person dies |
MassMutual also notes that some states levy their own estate tax and some have inheritance taxes that can apply to smaller estates.
State Estate Taxes Can Make Insurance Relevant Below $15 Million
Two law firms show how state rules change the planning.
| State | Rule from the source | Source |
|---|---|---|
| Minnesota | $3 million exemption, progressive rates of 13% to 16% | Hall PC |
| Massachusetts | A gross estate over $2.0 million requires a return, and a net estate over $2.0 million owes tax | Tamburro Law |
| California | No separate state estate tax | Lawvex |
Hall PC gives examples: a $4 million Minnesota estate owes tax on $1 million, roughly $130,000, and a $6 million estate owes tax on $3 million, above $400,000. It adds that taxable gifts made within three years before death are added back into the Minnesota taxable estate, though gifts within the federal annual exclusion are not “taxable gifts.” For families below the federal threshold, life insurance owned by a trust is therefore a state tax tool as much as a federal one.
Using Life Insurance in Estate Planning for Buy-Sell Agreements
Business owners often use insurance to fund a buyout when an owner dies. Greenleaf’s examples show how the structure decides the tax result.
| Structure | Result (Greenleaf Trust) |
|---|---|
| Owner holds a borrowing right on the policy that funds a cross-purchase | Full death benefit included in that owner’s estate |
| Corporation owns policies on owners to fund a redemption | Proceeds are not included in the estate, but the value of the deceased owner’s shares rises (in the example, by $180,000, 60% of $300,000) |
| Corporation-owned policy paid to the insured’s son | Insured is treated as controlling the policy, so the death benefit is included |
The Transfer-for-Value Rule
Beancount, a plain-text accounting company whose October 2026 blog post ends with a product pitch, explains the transfer-for-value rule under IRC section 101(a)(2). If a policy or any interest in it is transferred for “valuable consideration,” the death benefit exclusion shrinks: the new owner can exclude only the consideration paid plus later premiums, and the rest is taxable income. The post gives an example: a $1 million policy sold to a business partner for $80,000, followed by $30,000 in later premiums, leaves a $110,000 exclusion and about $890,000 of taxable death benefit.
Pure gifts, beneficiary changes, collateral assignments and Section 1035 exchanges generally do not trigger the rule. The five exceptions are a carryover basis transfer (including gifts), a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner and to a corporation in which the insured is a shareholder or officer. The post identifies the main buy-sell risk: transfers between individual shareholders of a corporation have no matching exception, so a cross-purchase among shareholders needs care.
Common Mistakes With Life Insurance in Estate Planning
- Owning the policy personally when an ILIT would keep it out of the estate: Greenleaf and Lawvex both explain that personal ownership brings the benefit into the taxable estate.
- Keeping a borrowing right or the ability to change beneficiaries. Greenleaf’s Rex example shows the whole benefit pulled into the estate.
- Transferring a policy late. The three-year rule applies.
- Skipping Crummey notices, which can turn annual gifts into taxable gifts.
- Naming the estate as beneficiary, which exposes proceeds to inclusion and probate.
- Selling a policy to a co-owner without checking the transfer-for-value rule.
- Transferring a policy carelessly. Tamburro Law notes the transfer is irrevocable and that gift tax may apply if the cash value exceeds the gift tax exclusion.
- Buying coverage that is too small or lapses, which MassMutual lists as the main caveat for survivorship policies.
Frequently Asked Questions About Life Insurance in Estate Planning
Is life insurance taxable to my heirs?
Generally not for income tax, according to Tamburro Law and MassMutual, but it can be included in the taxable estate if you own it or hold incidents of ownership.
What is an ILIT?
An irrevocable trust that owns your policy, so the proceeds are generally excluded from your estate. A trustee other than you administers it.
What is the three-year rule?
If you transfer an existing policy to an ILIT and die within three years, the proceeds are included in your estate.
Is second-to-die insurance worth it?
MassMutual says it typically gives a larger death benefit for the same premium than two separate policies and pays when estate costs come due, but the policy must stay in force and be large enough.
Do I need life insurance if my estate is under $15 million?
Possibly, because state estate taxes, business buyouts and liquidity needs can still apply, as Hall PC and Tamburro Law show for Minnesota and Massachusetts.
This article offers general information about life insurance and estate planning and is not legal, tax or insurance advice. Rules differ by state, several sources sell estate planning services or insurance and some contain outdated figures, so work with a qualified estate attorney and tax adviser.
Sources
- Lawvex, Gary Winter, “What Is an ILIT and Do You Need One in California?” (April 20, 2026, modified September 24, 2026; California law firm, promotional content) – https://lawvex.com/irrevocable-life-insurance-trust-ilit-guide/
- Hall PC, Aaron Hall, “Minnesota Irrevocable Life Insurance Trusts” (published December 9, 2016, updated April 16, 2026; Minnesota law firm) – https://aaronhall.com/practice-areas/minnesota-wills-estates-probate/minnesota-irrevocable-life-insurance/
- MassMutual, Shelly Gigante, “Survivorship insurance and estate planning” (April 22, 2026; insurer marketing blog) – https://blog.massmutual.com/insurance/survivorship-insurance-estate-planning
- Greenleaf Trust, George F. Bearup, “Life Insurance: The Incident of Ownership Rule” (metadata date October 25, 2022; the article body shows an earlier date) – https://greenleaftrust.com/missives/life-insurance-the-incident-of-ownership-rule/
- Beancount.io, Mike Thrift, “Transfer-for-Value Rule: When a Life Insurance Death Benefit Becomes Taxable” (October 2, 2026; accounting software vendor) – https://beancount.io/blog/2026/10/02/transfer-for-value-rule-life-insurance-death-benefit-taxable-guide
- Law Office of Dale J. Tamburro, “How To Avoid Taxation On Life Insurance Proceeds” (December 24, 2025; federal rules and Massachusetts) – https://www.tamburrolaw.com/how-to-avoid-taxation-on-life-insurance-proceeds
