The Role of Life Insurance in Estate Planning and Inheritance

The Premise Changed in 2025

Most published advice on this subject still assumes a federal estate tax cliff that no longer exists.

For years the planning conversation ran: the exemption is temporarily doubled, it reverts at the end of 2025 to roughly $7 million, so act now. That reversion was eliminated. The One Big Beautiful Bill Act, signed 4 July 2025, removed the sunset and raised the exemption instead.

Federal estate tax now reaches well under 0.1% of estates. If you were told to buy permanent insurance because of an approaching cliff, the reason you were given has gone.

The need did not disappear, though. It moved.

Where the Tax Actually Applies Now

Twelve states and the District of Columbia levy their own estate tax, at thresholds bearing no relation to the federal figure. A further five states tax inheritances — paid by the recipient rather than the estate — and Maryland does both. Iowa completed the phase-out of its inheritance tax on 1 January 2025.

Read the top of that list again. In Oregon a $1 million estate is exposed; in Massachusetts, $2 million. A family home, a retirement account and ordinary savings clear those thresholds in many parts of the country. This is no longer a conversation confined to business owners.

Two State Quirks That Cost Real Money

The cliff effect. Federal estate tax applies only to the amount above the exemption. Several states do not work that way — in New York and Massachusetts, exceeding the threshold can bring the entire estate into charge rather than only the excess. Crossing the line by a small margin produces a disproportionate bill, which makes valuation and timing far more consequential than the federal rules would suggest.

No portability. Federally, a surviving spouse can claim the deceased spouse's unused exemption, giving a couple up to $30 million. Most states with their own estate tax do not offer this. A couple in a no-portability state can lose the first spouse's exemption entirely unless the plan is structured to use it — typically through a credit shelter or bypass trust at the first death.

State rules also turn on domicile for most assets and on location for real property, so owning a holiday home in a taxing state can create exposure you did not plan for.

What Insurance Does That Other Assets Cannot

The federal estate tax return is due nine months after death, with an extension available for filing but generally not for payment. State deadlines vary and can be shorter.

That deadline is the whole problem. An estate consisting of a business, farmland, commercial property or restricted stock cannot produce cash in nine months without selling something — and a forced sale on a fixed deadline is a sale at a discount. Life insurance produces cash on death, at the moment it is needed, without reference to market conditions or transfer restrictions.

That is the mechanism. Everything else is about structuring it so the insurance does not become part of the problem.

The Non-Tax Uses Were Always the Stronger Case

Now that federal exposure has narrowed, these matter more, not less — and none of them depends on a tax threshold.

Estate equalisation. One child works in the family business or on the farm; the others do not. Leaving the operating asset to the one who runs it and cash to the others via a policy avoids the alternative — forcing a sale, or a buyout financed with debt, or joint ownership between siblings with irreconcilable interests. This is the use case that prevents the most family damage and it has nothing to do with the IRS.

Buy-sell funding. Without a funded agreement, the surviving partner may find themselves in business with a deceased partner's spouse who wants either a say or an exit and cannot get either. Insurance funds the purchase at a price agreed in advance, when nobody is negotiating under pressure.

Liquidity for ordinary costs. Funeral expenses, probate and legal fees, outstanding debts, and household running costs while an estate is administered. This applies at every level of wealth.

Providing for a dependant with lifelong needs, usually through a properly drafted special needs trust so the benefit does not disrupt means-tested support.

Ownership Is What Determines the Tax Treatment

Death benefits are generally received free of income tax under section 101(a) of the Internal Revenue Code. That is not the issue. The issue is the estate tax.

If the insured owned the policy — or held any incidents of ownership, such as the right to change beneficiaries, borrow against it or surrender it — the death benefit is included in the gross estate. So a policy bought to pay estate tax can itself increase the estate tax, which is a self-defeating outcome and an entirely common one.

The standard solution is an irrevocable life insurance trust, which owns the policy so proceeds fall outside the estate. The trustee can then lend money to the estate or buy assets from it, providing liquidity without adding to the taxable total.

The ILIT Detail Nobody Mentions

Three things determine whether an ILIT works, and the first is the one most often missed.

The three-year rule. Under section 2035, transferring an existing policy into an ILIT does not remove it from your estate if you die within three years of the transfer. The proceeds are pulled back in. The way around this is straightforward but has to be done at the outset: have the trust apply for and own the policy from inception, rather than transferring one you already hold. Doing it in the wrong order costs nothing to fix at the start and cannot be fixed afterwards.

Crummey notices. Premiums are funded by gifts to the trust. For those gifts to qualify for the annual exclusion, beneficiaries must receive notice of a temporary right to withdraw. These notices need sending every time, and documenting. Skipped notices are a routine audit finding.

Irrevocable means irrevocable. You cannot serve as trustee, cannot retain control, and cannot change your mind. Some states permit decanting into a new trust with different terms, but that is specialist legal work, not an adjustment.

An ILIT is a real legal structure with ongoing administration. It is worth it where there is genuine estate tax exposure. It is overkill where there is not, and it is sold to people who do not need it.

The Step-Up Question

Here is the consideration that has become more important as the exemption has risen, and that older planning material largely ignores.

Assets held at death generally receive a step-up in cost basis to their date-of-death value, wiping out unrealised capital gains for heirs. Assets moved into an irrevocable trust during life may not get that step-up.

For a family well below the state and federal thresholds, aggressively removing appreciated assets from the estate can therefore create a tax bill rather than avoid one — trading an estate tax that would never have applied for a capital gains tax that now will. The right answer depends on your actual exposure, which is why the state table above matters before any structure is discussed.

The Filing Nobody Remembers

Federal portability is not automatic. To preserve a deceased spouse's unused exemption, the estate must file a federal estate tax return — even when no tax is due — generally within nine months, with an extension available.

Surviving spouses skip this constantly, reasoning that with no tax owed there is nothing to file. The unused exemption is then lost, and the consequence appears only at the second death, when it is too late.

Five Mistakes

Owning the policy yourself when you have real exposure. Adds the death benefit to the taxable estate.

Naming your estate as beneficiary. Forces the proceeds through probate, exposing them to creditors and public record and destroying the direct, fast transfer that is the point. See what a beneficiary designation controls and what happens with no beneficiary named.

Stale designations. A divorce does not reliably revoke a beneficiary designation, and for employer plans governed by ERISA, federal law preempts state revocation statutes entirely.

Relying on group coverage. Capped low and it ends when employment does — often exactly when your health makes replacement expensive. See employer versus individual coverage.

Transferring a policy carelessly. The transfer-for-value rules can turn an otherwise tax-free death benefit into taxable income. Never change ownership of a significant policy without advice.

Two Situations

An illiquid estate on a nine-month clock

A founder's estate consists largely of stock subject to transfer restrictions, alongside a home. The valuation is substantial; the cash is not.

A policy owned by an irrevocable trust — applied for by the trust from the outset, avoiding the three-year rule — pays out on death outside the estate. The trustee lends the estate the cash it needs to settle liabilities on time.

The shares are not sold under deadline pressure. Which matters most where the asset is one whose value depends on not being liquidated at a fixed date.

The state threshold nobody had checked

A retired couple in a state with a low estate tax exemption hold a paid-off house, retirement accounts and modest savings. They consider themselves ordinary and assume estate tax is a problem for other people, which is true federally and not true locally.

Their combined estate exceeds the state threshold. Because their state does not offer portability, the first spouse's exemption is at risk of being wasted, and because the state applies a cliff, exceeding the threshold brings more into charge than the excess alone.

The remedy is structural and unremarkable — using both exemptions, and holding a modest policy for liquidity. The failure would have been not looking.

Both are composite illustrations, not accounts of specific individuals.

Where to Start

1. Total your estate — property, retirement accounts, business interests, and any life insurance you own, at current value.
2. Check your state's threshold, and any state where you own property.
3. Ask whether your state has a cliff and whether it offers portability. Both change the arithmetic substantially.
4. Calculate the nine-month cash requirement — taxes, debts, fees, and household costs during administration.
5. Compare that to your liquid assets. The gap is what insurance is for.
6. Only then consider structure. An ILIT where exposure is real; simple ownership and a clean beneficiary designation where it is not.
7. Weigh the step-up before moving appreciated assets out of your estate.
8. Review every beneficiary designation, including at work.

Frequently Asked Questions

Is the death benefit taxable?

Not for income tax purposes under section 101(a). It can be included in the taxable estate if the insured held incidents of ownership — which is what an ILIT is designed to prevent.

Do I need an ILIT?

Only if your estate is likely to face federal or state estate tax. Below those thresholds it adds cost and permanent inflexibility for no benefit. Start with the numbers, not the structure.

Can I put an existing policy into a trust?

Yes, but the three-year rule means the proceeds return to your estate if you die within three years of the transfer. Where possible, have the trust apply for a new policy instead.

What is a second-to-die policy?

Survivorship coverage insuring two lives and paying on the second death, which is generally when estate tax falls due for a married couple. It costs less than two individual policies because the insurer pays later.

Term or permanent for this purpose?

Estate tax liability does not expire, so term coverage risks the policy ending before the need does. Where the requirement is genuinely permanent, permanent insurance fits. Where the need is time-limited — a buy-sell over a defined horizon, or debts that will be repaid — term may be sufficient and far cheaper. See term versus whole life and, on cash value products, what to check before buying one.

What about private placement life insurance?

PPLI wraps institutional investments inside a policy for tax-advantaged growth. It requires accredited or qualified purchaser status and substantial minimums, and it is a family office instrument rather than a general strategy.

How much coverage?

Estimate the tax liability at your state and federal thresholds, add debts and administration costs, and include a buffer. Our calculator guide covers the method; the estate tax component sits on top of ordinary income replacement.

How often should I review this?

Every three years, and after any change in law, domicile, marital status or asset values. State thresholds move; two changed in 2025 and 2026 alone.

The Short Version

The federal case for insurance-funded estate planning narrowed sharply in 2025. The exemption is $15 million per person, permanent, and reaches almost nobody.

The state case did not narrow at all. Twelve states and DC tax estates, several starting at $1 million to $3 million, some with a cliff that taxes everything once you cross it and most without spousal portability. If you live in one, that is the threshold that applies to you.

And the strongest uses were never about tax: equalising an inheritance so one child does not have to buy out another, funding a buy-sell so a surviving partner is not in business with a widow, and producing cash in the nine months before an estate tax return is due. Check your state's number first. The structure conversation only makes sense after that.

Sources and Editorial Note

Federal estate and gift tax figures reflect the One Big Beautiful Bill Act (Public Law 119-21, enacted 4 July 2025), effective 1 January 2026, which set the exemption at $15 million per individual, removed the scheduled sunset and provided for inflation indexing from 2027; the top rate remains 40%. State estate and inheritance tax thresholds are as published for 2026 and are subject to legislative change — Washington's threshold changed mid-year and Iowa's inheritance tax phase-out completed on 1 January 2025. Policy inclusion rules arise under sections 2035 and 2042 of the Internal Revenue Code; income tax treatment of death benefits under section 101(a).

This article is general information, not legal, tax or financial advice. Estate planning is state-specific and fact-specific, thresholds and cliff provisions change, and the interaction between estate tax exposure and the step-up in basis requires individual analysis. Confirm current figures with the IRS and your state revenue department, and work with a licensed estate attorney and tax adviser before establishing any trust or transferring policy ownership. For carrier licensing and complaints, contact your state insurance department.