Is Life Insurance Part of Your Estate?

Life insurance provides a monetary benefit, known as the death benefit, to designated individuals upon the insured’s death. This offers financial protection to beneficiaries, helping to replace lost income, cover debts, or fund future needs. An individual’s estate includes all assets and liabilities they own at the time of their passing, such as real estate, investments, personal property, and outstanding debts. Understanding how life insurance death benefits interact with an estate is important for financial planning, involving considerations for both probate and taxation.

Understanding Estate Inclusion

The term “estate” has different meanings depending on whether it refers to the probate estate or the taxable estate. The probate estate includes assets that pass through a court-supervised process to validate a will and distribute property. Life insurance death benefits often avoid probate, directly reaching beneficiaries.

Even if life insurance proceeds bypass probate, they can still be counted as part of the deceased’s “gross estate” for federal or state estate tax purposes. The gross estate is a broader concept, representing the total value of all assets owned or controlled by an individual at death, used to calculate potential estate tax liability. Therefore, while a life insurance policy might not be subject to probate, its value could still be subject to estate taxes.

Policy Ownership and Estate Implications

The primary factor determining whether life insurance death benefits are included in a deceased person’s gross estate for estate tax purposes is policy ownership. If the insured individual held “incidents of ownership” in the policy at the time of their death, the death benefit is generally included in their gross estate. Incidents of ownership refer to economic rights over the policy, such as the power to change beneficiaries, surrender or cancel the policy, assign the policy, pledge it for a loan, or borrow against its cash value. Merely possessing these powers can lead to inclusion in the taxable estate.

When the insured owns the policy and possesses these incidents of ownership, the full death benefit contributes to their estate for estate tax calculations. For instance, if an individual owns a policy on their own life and retains the right to change the beneficiary, the proceeds are part of their taxable estate, regardless of who is named as the beneficiary.

Conversely, if a third party, such as a spouse, an adult child, or a business, owns the life insurance policy on the insured’s life, the death benefit is generally not included in the insured’s gross estate. This arrangement removes the policy from the insured’s direct control and, therefore, from their taxable estate. For example, a child might purchase and own a policy on a parent’s life, paying premiums and naming themselves as beneficiary.

In situations involving joint ownership, the implications can be more complex. If two individuals jointly own a policy, the portion attributable to the deceased’s ownership share may be included in their estate.

The “three-year rule” applies to policy transfers. If an insured transfers ownership of an existing policy to another person or entity within three years of their death, the death benefit will still be included in their gross estate for tax purposes. This rule prevents last-minute transfers to avoid estate taxes. However, this rule typically does not apply to policies where the insured never held any incidents of ownership from the policy’s inception.

Beneficiary Designations and Probate

Life insurance death benefits generally bypass probate when a specific beneficiary, other than the deceased’s estate, is named on the policy. Probate is a legal procedure that validates a will and oversees the distribution of a deceased person’s assets and debts. This court-supervised process can be time-consuming, expensive, and public.

When a life insurance policy has a designated individual or trust as its beneficiary, the insurance company typically pays the death benefit directly to that named party. This direct payment allows funds to be transferred outside of the probate court’s jurisdiction. Avoiding probate offers advantages, including increased privacy for beneficiaries, faster distribution of funds, and reduced administrative costs and legal fees.

However, if the deceased’s estate is named as the beneficiary, or if no living beneficiaries are designated, the death benefit becomes part of the probate estate. In such cases, the insurance proceeds are subject to probate, like other assets without direct beneficiaries or joint ownership. This means funds could be used to pay the estate’s debts and administrative expenses before distribution to heirs. Naming the estate as beneficiary can expose proceeds to creditors and delay access by intended heirs.

Federal and State Estate Tax Treatment

If a life insurance policy’s death benefit is included in the deceased’s gross estate, its value contributes to federal estate tax calculations. The federal estate tax applies only to estates exceeding a specific exemption amount. For individuals dying in 2025, this exemption is $13.99 million. Only the portion of the estate’s value exceeding this threshold is subject to federal estate tax.

For married couples, the 2025 exemption allows for a combined $27.98 million. The federal estate tax rate can be as high as 40% on the taxable portion of the estate.

Some states impose their own estate taxes, inheritance taxes, or both. State estate tax thresholds are often lower than the federal exemption, meaning an estate might be exempt federally but still subject to state taxation. State estate taxes are typically levied on the total value of the deceased’s estate before distribution. Inheritance taxes are paid by the beneficiaries receiving the assets, with rates varying based on the beneficiary’s relationship to the deceased.

Estate Planning for Life Insurance

Strategic estate planning can manage how life insurance impacts one’s estate, particularly regarding potential estate taxes. A prominent tool is the Irrevocable Life Insurance Trust (ILIT). An ILIT’s primary objective is to remove life insurance proceeds from the grantor’s taxable estate, reducing potential estate tax liability.

An ILIT is an irrevocable trust designed to own life insurance policies. Once a policy is transferred to or purchased by an ILIT, the grantor (the person who sets up the trust) gives up all incidents of ownership. This ensures death benefit proceeds are not included in the grantor’s gross estate. Upon the insured’s death, the death benefit is paid directly to the ILIT, which then distributes funds to the trust beneficiaries according to the trust’s terms.

Funding an ILIT typically involves the grantor making cash gifts to the trust, which the trustee uses to pay policy premiums. These gifts can qualify for the annual gift tax exclusion, which is $19,000 per recipient in 2025. Utilizing the annual exclusion allows the grantor to fund the trust without eroding their lifetime gift tax exemption or incurring gift taxes. The trustee manages the trust, including accepting funds, paying premiums, and distributing proceeds.

If an existing policy is transferred into an ILIT, the three-year rule applies; the death benefit will be included in the grantor’s estate if death occurs within three years of the transfer. However, if the ILIT purchases a new policy from its inception, the three-year rule does not apply.