Are Life Insurance Proceeds Taxable to a Trust?

Whether life insurance proceeds paid to a trust are taxable involves navigating income tax, estate tax, and other transfer taxes. The final tax outcome depends on the structure of the trust and the ownership of the policy. The tax treatment hinges on which tax is being considered and how the entire arrangement was initially established and maintained.

The General Income Tax Rule for Death Benefits

The payment of a life insurance death benefit to a beneficiary, including a trust, is not subject to federal income tax. The Internal Revenue Code states that gross income does not include amounts received under a life insurance contract if paid by reason of the insured’s death. This exclusion applies whether the beneficiary is an individual, a corporation, or a trust.

An exception to this rule is the “transfer-for-value” rule, which can make the death benefit partially taxable if the policy was transferred for valuable consideration. For example, if a business owner sells a policy on their life to a partner to fund a buy-sell agreement, the tax-free status is compromised.

When the insured passes away, the new owner can only exclude the amount they paid for the policy plus any subsequent premiums from their taxable income. The remainder of the death benefit would be treated as taxable ordinary income.

Estate Tax Implications for Trusts

The federal estate tax is a tax on the transfer of a person’s assets after their death. For 2025, the federal exemption is $13.99 million per individual, but this amount is scheduled to be reduced to an inflation-adjusted amount of approximately $7 million on January 1, 2026. Life insurance proceeds can be included in the calculation of the deceased’s gross estate, potentially pushing its value over the threshold.

Life insurance proceeds are included in the estate if the deceased retained “incidents of ownership” over the policy within three years of their death. These rights include the ability to change the beneficiary, surrender or cancel the policy, or borrow against its cash value. If the proceeds are paid to the deceased’s estate or to a revocable living trust, the full amount is added to the gross estate.

To avoid this outcome, many individuals use an Irrevocable Life Insurance Trust (ILIT). An ILIT is a trust created to own and be the beneficiary of a life insurance policy. When the trust is properly structured, the proceeds are not considered part of the deceased’s estate and are not subject to federal estate tax.

For this to be effective, the insured person cannot act as the trustee and must relinquish all control over the policy and the trust. Funding often involves annual gifts to the trust to cover premium payments, which can be structured to qualify for the annual gift tax exclusion of $19,000 per donor, per recipient in 2025. This strategy can also be relevant for state estate or inheritance taxes, which have much lower exemption amounts.

Income Taxation of the Trust After Receiving Proceeds

Once a trust receives life insurance proceeds, the initial receipt of the death benefit is income-tax-free. The tax considerations shift at this point to the management and distribution of those funds. The proceeds become part of the trust’s principal, and the trustee has a fiduciary duty to invest this capital according to the trust document.

Any earnings generated from the investment of these proceeds are subject to income tax. This new income, which could be in the form of interest or dividends, is taxable to the trust. The trust is a separate taxable entity and is required to file an annual income tax return to report its income, deductions, and gains.

The concept of Distributable Net Income (DNI) determines who pays the tax on this investment income. If the trust distributes its earnings to the beneficiaries, the trust can take an income distribution deduction, and the income is then reported by the beneficiaries on their personal tax returns. If the trust retains the income, it is responsible for paying the income tax at compressed trust tax rates; in 2025, a trust’s income is taxed at the highest marginal rate of 37% once it exceeds $15,650.

Generation-Skipping Transfer Tax Considerations

A separate tax that can apply to life insurance proceeds in a trust is the Generation-Skipping Transfer (GST) tax. This federal tax is imposed in addition to any applicable estate tax and is designed to prevent families from avoiding wealth transfer taxes by passing assets directly to beneficiaries who are two or more generations younger, such as grandchildren. The GST tax is levied at the highest federal estate tax rate, which is 40%.

This tax becomes relevant when a trust, particularly a long-term “dynasty trust,” holds life insurance proceeds for the benefit of multiple generations. A dynasty trust is structured to last for a long time, providing benefits to children and grandchildren. If life insurance proceeds are paid into such a trust, distributions to grandchildren could trigger the GST tax.

To mitigate this tax, every individual has a lifetime GST tax exemption, which is unified with the federal estate tax exemption. A person can allocate their GST exemption to the assets transferred to the trust, such as the life insurance policy or the cash used to pay its premiums. By allocating the exemption, the life insurance proceeds and all future appreciation on those assets inside the trust are sheltered from the GST tax for the duration of the trust.