Using Life Insurance for Tax-Efficient Wealth Transfer

Life insurance is a powerful tool. It can cover immediate expenses after the loss of a spouse, but also much more. Many Americans do not have a life insurance policy outside their employer, which leaves them uncovered if they become unemployed or retire. The Life Insurance Marketing and Research Association (LIMRA) reported that 67% of workers relied solely on workplace life insurance in 2023. To understand why having a personal life insurance policy is important, individuals must first learn what it can do for them. Life insurance can supplement income and pay debt, but as families plan for the future, life insurance can be instrumental in settling an estate. Here’s how life insurance can minimize estate taxes and streamline the transfer of assets to heirs and beneficiaries.

Leveraging Life Insurance for Estate Planning

Whole life insurance policies are considered permanent, covering the policyholder until death. These policies generally offer a tax-free death benefit for beneficiaries. However, if the insured owns the policy at their death, the proceeds may be considered part of the taxable estate. Families can avoid this through an Irrevocable Life Insurance Trust (ILIT), which takes ownership of the policy, thereby keeping the death benefit out of the taxable estate. 

The Role of Irrevocable Life Insurance Trusts (ILITs)

An ILIT is a trust that owns and controls a life insurance policy on behalf of an individual. Once a policyholder transfers the policy to an ILIT, the death benefit is no longer part of their estate, potentially reducing estate taxes. ILITs can protect assets from creditors and ensure that the management of the proceeds honors the grantor’s wishes.

Tax Benefits and Considerations

Strategic use of life insurance can offer numerous tax advantages that make it appealing for wealth transfer. These include the following:

• Estate Tax Exclusion: Life insurance proceeds paid to a properly structured ILIT are not subject to estate taxes.
• Gift Tax Strategies: ILIT contributions can qualify for an annual gift tax exclusion. Beneficiaries must have “Crummey powers” allowing them to withdraw contributions for a limited time. Crummey powers originate from Clifford Crummey, a wealthy grantor, who in the 1960s wanted to build a trust fund for his children while still receiving annual tax exemption benefits. Crummey powers allow a person to transform a gift that is not eligible for a gift-tax exclusion into one that is. Individuals must identify and stipulate the gift upon drafting the trust. The gift amount can’t exceed the regular gift tax exclusion, $19,000 in 2025.
• Generation-Skipping Transfer Tax (GSTT) Planning: Provisions within ILITs can benefit multiple generations, and potentially minimize GSTT taxes, which are federal gift taxes that prevent donors from avoiding estate taxes by skipping children in favor of grandchildren.

Practical Applications

Families are increasingly using life insurance to combat potential inheritance tax liabilities. The anticipated reduction of the federal estate and gift tax exemption at the end of 2025 is a significant factor driving this trend. The current, historically high $13.99 million per individual is set to decrease to approximately half that amount. Life insurance can offer immediate liquidity to fulfill estate tax obligations, especially when liquid assets like real estate or businesses comprise a considerable percentage of an estate. Integrating life insurance into an estate plan can safeguard against heirs feeling compelled to sell valuable assets in unfavorable conditions to meet tax liabilities.

Implementing a Life Insurance Strategy

Adding life insurance to an estate plan requires careful and vigilant planning to get the most benefit. Individuals who want to use life insurance as part of their wealth transfer strategy should do the following:       

• Consult Professionals: Estate planning involves complex tax rules, legal structures, and personal financial goals. It’s not easy for a novice to navigate. Experienced professionals like estate planning attorneys, financial advisors, and tax consultants can distill matters and help individuals make decisions that align with and promote their goals. They can also assist with choosing an insurance policy, setting up an ILIT, and structuring premium payments.
• Consider Timing: The Internal Revenue Service (IRS) may include life insurance proceeds in a taxable estate if the policy is transferred within three years of the holder’s death. Timing is essential, and to avoid this, a policyholder should plan early, lock in lower premiums in good health, and use ILITs to their advantage.
• Review Regularly: Financial priorities shift with time, estate laws change, and family circumstances evolve. Regular assessments ensure that ILITs remain aligned with an individual’s goals, that beneficiaries are up-to-date, and policies stay funded and compliant.

More than a safety net, life insurance can protect an individual’s legacy after death. It can provide tax-free liquidity, reduce estate tax burdens, and efficiently transfer wealth across generations. Professional advice and tools like ILITs can help families protect loved ones from financial strain. With potential tax law changes, the time to integrate life insurance into your estate plan is now. If you want to build a tax-efficient bridge toward a secure financial future for your beneficiaries, SHP Financial can help. Contact us today for a complimentary assessment of your finances.