house with large tree

Is Life Insurance the Best Estate Tax Solution?

Life insurance has long been sold as a solution for paying burdensome estate and generation skipping taxes. It’s simple and free of income tax — it’s all you need to do, right?

Under the right circumstances, life insurance can be a useful tool in estate tax planning. However, more commonly, effective estate tax management involves a variety of other financial planning techniques that may enable you to avoid these taxes altogether.

A significant tax bill

The American Taxpayer Relief Act of 2012 increased the amount one can give to heirs free of gift/estate tax to roughly $5.45 million for an individual and, with appropriate planning, potentially more than $10.9 million for a married couple. Similar exemptions apply for the generation skipping transfer (GST) tax, which is triggered when a person gives part or all of their estate during their lifetime or at death to grandchildren, great-grandchildren or other family members who are at least two generations removed from them.

Estate values that exceed the lifetime exemption amounts face a 40% federal estate tax. In addition, the 40% GST tax and state inheritance and estate taxes can add even more to the tax bill.

With few exceptions, these taxes are generally due in cash nine months after death — an imposing liability for wealthy families.

Sometimes life insurance can help

Life insurance is a very unique financial asset and, in some circumstances, a permanent policy that lasts an insured’s lifetime can be very valuable to a cash-strapped estate. If the estate is primarily comprised of illiquid assets — a private business, real estate, art and other collectibles intended to be preserved for future generations — raising cash can be a challenging and costly endeavor (think “fire sale”). In these situations, the cash provided through the policy’s death benefits may substantially ease the liquidity crunch when it comes time to pay the estate tax.

And sometimes it doesn’t

However, as an estate tax-management vehicle, life insurance should not be held by the estate owner. That’s because the policy death benefit would still be subject to the estate tax, thereby aggravating the exact problem you are trying to manage.

To address this concern, life insurance is commonly purchased in an irrevocable life insurance trust (ILIT) to eliminate estate taxation on the death benefit. But then the premium payments are treated as gifts, and we must ask ourselves whether this is the best use of one’s tax-free gift-giving capacity. Even when it is, to qualify for gift tax-free treatment, several administrative steps must be taken annually.

Furthermore, while life insurance can result in a significant economic windfall if the insured dies early, a premature death is unlikely. It’s more realistic to assume (and hope) that the Grim Reaper will arrive closer to when the insurance carrier estimates death, otherwise known as “life expectancy.” The economic return (comparing the death benefit to the premiums paid) at life expectancy for a properly funded policy is fairly modest — for a traditional, non-variable life policy, expected long-term returns will likely be around 2% to 4%.

Other limitations of life insurance include:

  • A long-term cash flow commitment (annual premiums)
  • Heirs must wait until death to receive money
  • Coverage is only available to individuals with good health. If your estate continues to appreciate, you cannot always count on being able to buy additional life insurance to address the growing estate tax problem.
  • Policies have their own specialized risks to be considered and managed, including:
    • Carrier risk – the financial health of the insurance company
    • Policy performance risk – most life insurance policies are structured based on non-guaranteed assumptions of policy earnings and expenses

The bottom line is that relying on life insurance as the sole solution to managing one’s estate taxes is not usually an effective strategy. Other planning techniques can provide greater long-term benefits.

A treasure chest of solutions

By far, the greater potential for estate tax management comes from a treasure chest of techniques that aim to reduce the growth of the tax and, in some cases, avoid it completely. Often, clients would be better off using these other strategies before buying life insurance.

The common link among these various techniques is that they each involve a transfer of assets to persons or entities (e.g., trusts) that are not subject to the estate tax at your death. The name of the game is to get assets and the future appreciation of those assets out of your estate. The challenge is that making effective transfers for estate tax purposes also involves navigating the gift tax laws.

Under the lifetime gift and estate tax exemptions mentioned earlier, individuals have a finite capacity to make tax-free gifts. The goal is to maximize the use of this limited opportunity to achieve the most estate tax reduction in the future. Strategies may include direct gifts and more sophisticated solutions that leverage the gift tax exemption and reduce the taxable value, sometimes to zero.

For example, clients are often better off investing what would be spent on life insurance premiums into a long-term, diversified portfolio, as well as deploying other techniques to reduce or avoid the estate tax liability.

Consider this: You could invest $1.16 million in a life insurance policy over 25 years, which could pay a $1.87 million death benefit, and save about $747,000 in estate taxes. Or you could gift the annual premium amount in the form of an asset earning 8% and save nearly twice as much in estate taxes while transferring more wealth to your heirs. A lump-sum gift might be even better. Keep in mind however, if the non-insurance gift is sold, the capital gains taxes could diminish the estate tax savings.

Long-term benefits of an insurance policy vs. invested gift


Life insurance in trust

Annual gift earning 8%

One-year, lump sum gift earning 8%

Value in 25 Years


Estate Tax Saved


Example assumes a policy premium or investment amount of $46,340 annually, totaling $1,158,500 over 25 years (or year-one lump sum). Insurance value based on a hypothetical whole-life policy for a 65-year-old male and a $1,868,000 death benefit in year 25.

Much attention is spent on accumulating wealth. But substantial wealth accumulation without smart, cost-effective preservation planning leads to unnecessary taxes. Buying life insurance to deal with an expected future estate tax might seem like an easy solution, but with more thought and consideration of other options, a more complete solution may be available.

That’s why it’s important to have a talented and experienced advisory team evaluate your specific situation and help you conserve your wealth through effective estate tax management.