Are Life Insurance Proceeds Taxable to the Estate?

Life insurance proceeds are generally not subject to income tax for the beneficiary. However, these same proceeds can be included in the deceased person’s estate and become subject to federal and state estate taxes under certain conditions. Income tax is levied on earnings, while estate tax is a tax on the total value of a person’s assets at death. The inclusion of life insurance in an estate for tax purposes relates to the control the deceased person maintained over the policy.

The General Rule for Beneficiaries

When a life insurance policy pays out, the individuals named as beneficiaries receive the death benefit free from federal income tax, provided it is paid in a single lump sum. The Internal Revenue Service does not consider these proceeds to be gross income for the recipient, which aligns with the primary purpose of life insurance: to provide financial support to survivors.

This tax treatment is also common at the state level, with most states mirroring the federal stance. A notable exception is the “transfer-for-value” rule, which can trigger income taxation if the policy was sold or transferred for a valuable consideration. For most beneficiaries, the proceeds arrive as a tax-free lump sum.

If beneficiaries opt for payment structures other than a lump sum, income tax can become a factor. If the proceeds are placed into an account that generates interest, or are paid out over time as an annuity, the interest earned on the principal death benefit is considered taxable income. The original death benefit amount remains tax-free, but any additional earnings are subject to income tax.

When Proceeds Are Included in the Gross Estate

A life insurance death benefit can be included in the deceased’s gross estate for tax purposes if the individual retained “incidents of ownership” in the policy at the time of their death. This concept refers to having any rights or economic benefits associated with the policy. If the deceased held even one of these rights, the full value of the proceeds is pulled into their estate.

Incidents of ownership are defined as having specific powers over the policy, including the ability to:

• Change the beneficiary
• Surrender or cancel the policy
• Assign the policy to another person or revoke an assignment
• Pledge the policy as collateral for a loan
• Borrow against the policy’s cash surrender value

The “three-year look-back rule” is another factor. This rule states that if a policyholder transfers ownership of their policy to another person or a trust and dies within three years of that transfer, the life insurance proceeds are still included in their taxable estate. This provision prevents individuals from giving away policies shortly before death to avoid estate taxes.

The inclusion of proceeds is not dependent on who paid the premiums. Even if another person paid all the policy premiums, if the insured individual legally possessed any incidents of ownership at death or within the three years prior, the death benefit is considered part of their gross estate. This makes the legal ownership of the policy the determining factor.

Calculating and Paying the Estate Tax

When life insurance proceeds are included in a gross estate, they are added to the value of all other assets owned by the decedent. For 2025, the federal estate tax exemption is $13.99 million per individual. This high exemption is temporary and is scheduled to expire at the end of 2025. Beginning in 2026, the exemption is set to revert to its prior level, projected to be approximately $7 million after adjusting for inflation.

While the federal threshold is high, the situation can be different at the state level. A number of states impose their own estate tax, and their exemption amounts are often significantly lower than the federal limit. This means an estate might not trigger federal estate tax but could still be subject to a state-level tax, especially with the inclusion of a life insurance policy.

The estate’s executor or personal representative is required to file an estate tax return if the gross estate’s value exceeds the federal exemption amount. Any estate tax that is due is paid directly from the estate’s assets before distribution to heirs. The liability belongs to the estate as a whole, not the individual beneficiaries of the life insurance policy.

Planning Strategies to Avoid Estate Taxation

To prevent life insurance proceeds from being included in a taxable estate, the insured person must not possess any incidents of ownership at the time of death. The most direct way to achieve this is to have someone else, like an adult child, own the policy from the outset or to transfer ownership of an existing policy.

A more common strategy is the use of an Irrevocable Life Insurance Trust (ILIT). An ILIT is a legal entity created specifically to own a life insurance policy. When properly established, the trust is designated as both the owner and the beneficiary of the policy, and the insured individual relinquishes all incidents of ownership.

To implement this, the person creating the trust (the grantor) makes financial gifts to the trust, and the trustee uses those funds to pay the policy premiums. Upon the insured’s death, the insurance proceeds are paid directly to the ILIT. The trustee then manages and distributes the funds to the trust’s beneficiaries according to the trust document, keeping the proceeds outside the taxable estate.

Remember the three-year look-back rule when transferring an existing policy into an ILIT. To avoid this rule, it is often recommended that the trust be established to purchase a new policy directly, rather than accepting a transfer of an existing one. Setting up an ILIT is a complex legal process that requires drafting by an experienced attorney.