Should You Add Life Insurance to Your Estate Plan?

For many families, life insurance is a way to replace lost income in the event a parent or spouse dies unexpectedly. But it can also be a valuable estate-planning tool for those who want to leave significant wealth to their heirs.

Inheriting a large sum is not without its challenges, but with the right life insurance policy, you can help ensure your family members are able to address those challenges without having to break up the estate. Consider these life insurance options to help protect your estate and your loved ones.

There are two main types of life insurance:

• Term life insurance provides coverage for a fixed period of time (typically between 10 and 30 years). This type of policy is best suited for those with finite insurance needs—say, to provide for minor children until they come of age. The limited coverage makes it relatively affordable, particularly for young, healthy individuals.
• Permanent life insurance, on the other hand, provides lifetime coverage, making it suitable for estate planning. However, such coverage can come at a steep cost—typically five to 15 times that of a term policy. You can choose between either a whole life policy, which offers fixed premiums (unless you withdraw or borrow from it) and a guaranteed death benefit, or universal life insurance, which has lower, flexible premiums and may allow you to change the death benefit. Generally, you should purchase permanent life insurance only if your estate is large or complex enough to demand it.

In particular, permanent life insurance is most beneficial to those who want or need certain financial protection for their loved ones. For example, permanent life insurance coverage can help:

Estates worth more than $13.99 million ($27.98 million for married couples) in 2025 are subject to taxation of up to 40%. What's more, the tax bill is typically due within nine months of the estate owner's death, which can pose a burden on heirs who inherit estates with significant illiquid assets, such as art, real estate, or a business. A life insurance payout can keep your heirs from having to rush to sell those assets, potentially at below-market valuations.

Even if your estate doesn't exceed the current exemption, future tax changes are inevitable. Over the past five decades, there have been no fewer than 10 significant changes to federal estate tax laws, which creates a lot of uncertainty when it comes to estate planning. And barring action for Congress, the estate tax exemption limit could be halved at the end of the year when the current provision is set to expire.

It's not uncommon for an estate owner to have assets that are difficult to divvy up among their heirs. Family businesses and real estate, in particular, can be tough to bequeath to multiple heirs—especially if they don't have a shared vision for that asset. With life insurance, you can leave bigger assets to the appropriate heirs and offset any inheritance inequities with a policy of similar value.

When you have an heir who may never be able to provide for themselves, creating a plan for their financial security is paramount. But the cost of lifelong care can undercut other heirs' inheritances. In such cases, life insurance can be a great way to provide specific financial support for an heir with disabilities while leaving the rest of the estate intact. Just be careful when leaving assets to an heir who receives government benefits, such as Social Security Disability Insurance, as some programs have strict income limits, and the payout could affect their eligibility (see "Special needs trust").

Taking out a large life insurance policy can also add to the value of your estate, potentially diminishing the benefit of purchasing the policy in the first place. However, if you name an irrevocable trust as the beneficiary of your policies, the proceeds generally can be excluded from your estate and therefore be exempt from federal estate taxes. In addition, it provides immediate liquidity for your heirs to cover any outstanding estate fees or necessary expenses.

Two popular types of irrevocable trusts are often funded by life insurance:

• Irrevocable life insurance trust (ILIT): In such arrangements, the grantor transfers ownership of an existing policy to the ILIT or pays the premiums on a policy purchased by the trust. Since the ILIT's ownership of the policy is irrevocable—meaning it cannot be changed—the proceeds would not be considered part of your estate. (The proceeds generally are excluded from the insured's gross estate as long as the insured didn't hold any incidents of ownership, such as changing the beneficiary or borrowing against the policy, at the time of death or within the three-year period prior to death.) Once the trust receives the policy's proceeds, the trustee can use the funds to cover taxes and fees and/or manage payouts to heirs.
• Special needs trust (SNT): For dependents with disabilities, a direct inheritance of as little as $2,000 could reduce or eliminate their government benefits. Creating an irrevocable SNT can help avoid this pitfall by stipulating that it will cover only qualified education, equipment, insurance, and health care expenses not covered by federal or state benefits. Because the trustee pays the heir's expenses directly, no money flows to the dependent, which should preserve their government benefits.

For both permanent and term life insurance plans, your beneficiaries typically won't owe taxes on the death benefit when received as a lump sum. However, if they opt to receive the death benefit in installments, the total payout will be placed in an interest-bearing account and any earnings on the payments will be taxed as ordinary income.

Taxes on life insurance shouldn't be only a concern to your heirs and estate once you're gone, but you should also be aware of any tax consequences that can affect you while you're alive. For example, with permanent life insurance, the growth in cash value isn't taxed as income for the policyholder.

Also, you can also borrow or withdraw funds from your permanent life policy tax-free so long as the amount doesn't exceed what you've paid in premiums, or your cost basis. Any amount over your cost basis will count toward your taxable income.

Finally, should you decide you no longer need your permanent life insurance policy, you could surrender it for its cash value—though you'll owe income tax on any appreciation. If you're charitably inclined, you could donate your policy to a qualified charitable organization, providing a means for you to possibly reduce your estate taxes and the potential for you or your estate to claim the donation as an income tax deduction.

The tax advantages, and implications, of life insurance can be complex. A tax advisor will be aware of any tax law changes and can help you find strategies that align with your estate plan and financial situation.

If you're looking to incorporate life insurance into your estate plan, consider speaking to an estate attorney and a tax professional as soon as possible. Also, an insurance broker can explain your options—including supplementing your coverage with life insurance riders that can meet any current or future needs and identifying suitable life insurance companies—as well as help determine the amount of life insurance coverage required to give you peace of mind. The younger and healthier you are, the cheaper your policy will be. So once you've decided that life insurance is right for you, the time to act is now.