232 / Are life insurance proceeds from an irrevocable trust taxable? How can an ILIT be used as an estate planning tool?

While life insurance proceeds are an income tax-free benefit,¹ they are includable in the insured’s estate for estate tax purposes if the proceeds are payable: (1) to the estate, either directly or indirectly; or (2) to named beneficiaries, if the insured possessed any incidents of ownership in the policy at the time of death.²

For individuals with a large estate tax liability, using insurance proceeds can worsen this tax burden by inflating the insured’s gross estate for federal estate tax purposes.³ Using an ILIT can allow death proceeds from the life insurance to pass into the trust, where funds can be distributed income tax-free to the trust beneficiaries as directed by the trust documents. By avoiding the insured’s estate, insurance proceeds in an ILIT do not increase the estate of the decedent, thus avoiding additional estate tax.

1. IRC § 101(a)(1).

2. IRC § 2042.