Are Life Insurance Proceeds Included in Gross Estate?

A frequent question in estate planning is whether the proceeds from a life insurance policy are counted in the deceased’s gross estate for federal estate tax purposes. The answer depends on the policy’s ownership and beneficiary designations at the time of death. Under specific conditions defined by the Internal Revenue Code, these proceeds can be included.

A person’s gross estate represents the total value of all their assets and interests at the time of their death. This calculation is the starting point for determining if any federal estate tax is owed. For an estate to owe federal tax, its value must exceed the federal exemption threshold, which for 2025 is $13.99 million per individual. Because life insurance proceeds can increase an estate’s value, they can push an otherwise non-taxable estate over this limit. This exemption amount is scheduled to revert to a lower level after 2025 if Congress does not act to extend the current law.

When Life Insurance is Included in a Gross Estate

The inclusion of life insurance proceeds in a decedent’s gross estate is governed by two primary conditions under the Internal Revenue Code. The first is when the proceeds are receivable by the decedent’s estate. This occurs if the estate is named as the policy’s beneficiary or if the proceeds are paid to a third-party beneficiary who is legally obligated to use the funds to pay the estate’s debts, taxes, or other administration expenses. In these situations, the proceeds are automatically pulled into the gross estate.

The second condition applies when the proceeds are payable to a beneficiary other than the estate, like a child or trust. The proceeds will be included in the gross estate if the deceased person possessed any “incidents of ownership” in the policy at the time of their death. This means if the decedent retained certain rights and controls over the policy, the IRS considers them to have had a sufficient connection to the policy for its value to be part of their estate.

Understanding Incidents of Ownership

The term “incidents of ownership” is not limited to formal ownership in the way one might own a house or a car. Instead, it refers to the right of the insured or their estate to the economic benefits of the policy. Possessing even one of these rights at the time of death is sufficient for the entire death benefit to be included in the gross estate for tax purposes. This broad definition is designed to capture situations where an individual effectively controls the policy, even if they do not formally “own” it. The specific rights that constitute incidents of ownership are defined within Treasury Regulations and include:

• The right to change the beneficiary of the policy.
• The ability to surrender or cancel the policy.
• The power to assign the policy to another person or to revoke a previous assignment.
• The right to pledge the policy as collateral for a loan.
• The ability to borrow directly against the policy’s cash surrender value.

How Policy Ownership Affects Estate Inclusion

The structure of a life insurance policy’s ownership has direct consequences for estate tax inclusion. When an individual purchases a policy on their own life and names themself as the owner, the proceeds are almost certain to be included in their gross estate. This is because the policy owner inherently possesses all the incidents of ownership, such as the right to change beneficiaries or surrender the policy.

A different outcome arises when the policy is owned by another person, such as an adult child or a spouse. If the insured individual has no incidents of ownership and another person is the owner and beneficiary, the proceeds are not included in the insured’s gross estate. For this to be effective, the insured must not have the power to make any decisions regarding the policy. The owner would be responsible for paying premiums and would be the only one with the authority to make changes.

To formalize this separation, many people use an Irrevocable Life Insurance Trust (ILIT). An ILIT is a specific type of trust created for the sole purpose of owning a life insurance policy. When structured correctly, the trust owns the policy, and the trustee manages it according to the trust’s terms. Since the insured individual holds no incidents of ownership, the death benefit is paid to the trust and is not included in their gross estate. The proceeds can then be used by the trustee for the benefit of the trust’s beneficiaries, such as providing them with liquidity to pay estate taxes.

The Three-Year Look-Back Rule

The tax code includes a provision to prevent individuals from avoiding estate taxes by simply transferring ownership of their life insurance policy shortly before they die. This is known as the three-year look-back rule. If an individual transfers a life insurance policy or relinquishes their incidents of ownership within three years of their death, the full value of the proceeds will be brought back into their gross estate. This rule effectively treats the last-minute transfer as if it never happened for estate tax purposes, and the policy’s death benefit is included in the decedent’s taxable estate.

For example, if a person transfers ownership of their $2 million life insurance policy to their son on March 1, 2024, and then passes away on February 1, 2027, the transfer falls within the three-year window. Consequently, the entire $2 million in proceeds would be included in the parent’s gross estate. Had the parent lived beyond March 1, 2027, the proceeds would have been successfully excluded from the estate, assuming the transfer was complete and irrevocable.