Life insurance and the federal estate tax

A life insurance death benefit is free of income tax for the beneficiary, but it can still be added to the insured's estate for federal estate tax. Under 26 U.S.C. §2042, proceeds are included in your gross estate if they are payable to your estate, or if you held "incidents of ownership" in the policy at death. For 2026 the estate tax only bites above a $15,000,000 exclusion per person, so most families owe nothing, but owners of large policies and large estates need to plan.

The 2026 numbers

The federal estate tax applies to the value of everything you own or control at death above the basic exclusion amount. According to the IRS, the 2026 basic exclusion is $15,000,000 per person, up from $13,990,000 in 2025. Public Law 119-21, the 2025 tax law known as the One Big Beautiful Bill Act, set the amount and indexes it for inflation with no scheduled sunset. The top rate on amounts over the exclusion is 40% (26 U.S.C. §2001(c)).

Three features reduce the number of people affected:

• Unlimited marital deduction. Property left to a U.S. citizen spouse is deducted under §2056, so no estate tax is due until the second death.
• Portability. A surviving spouse can generally add the deceased spouse's unused exclusion by filing an estate tax return (§2010(c)). A married couple can therefore shelter up to $30,000,000 in 2026 if the return is filed.
• Annual and lifetime gifts. The 2026 annual gift tax exclusion is $19,000 per recipient. Larger gifts use up the same lifetime exclusion. See gift tax and life insurance premiums.

When a policy counts toward your estate

Section 2042 has two triggers:

1. Payable to your executor or estate. If the proceeds are receivable by or for the benefit of your estate, they are included. Naming the estate as beneficiary also sends the money through probate (see why naming your estate as beneficiary is usually a mistake).
2. Incidents of ownership. If you, alone or with someone else, held any incident of ownership at death, the full death benefit is included, even if your child is the named beneficiary. Incidents include the right to change the beneficiary, surrender or cancel the policy, assign it, borrow against it, or pledge it for a loan. A reversionary interest worth more than 5% of the policy value also counts.

The consequence surprises many people: owning a $2 million policy on your own life, with your children as beneficiaries, adds $2 million to your taxable estate. Who is the owner is therefore the key question; see policy owner vs insured: why it matters.

A policy that pays the insured's spouse is not itself taxed at the first death if the spouse is the beneficiary and the marital deduction applies, but the money lands in the surviving spouse's estate unless it is spent or placed in trust.

How to keep proceeds out of the estate

The standard approaches:

• Have someone else own the policy. An adult child or a trust can buy a new policy on your life and pay the premiums with gifts from you. The insured then holds no incidents of ownership. An irrevocable life insurance trust is the common vehicle, with a trustee as owner and beneficiary; see irrevocable life insurance trusts.
• Transfer an existing policy. This works, but only if you survive three years. Under §2035, a policy given away within three years of death is pulled back into the estate. See the three-year rule for transferring a policy.
• Avoid the Goodman triangle. If one person owns, another is insured and a third is beneficiary, the owner may make a taxable gift at death. See The Goodman triangle: an expensive ownership mistake.
• Use a survivorship policy. A second-to-die policy owned by a trust can provide cash at the second death, when the tax is usually due. See survivorship (second-to-die) life insurance.

A hypothetical example

The following is hypothetical and uses 2026 law.

Say Dana, a widow, owns a house, investments and a business interest worth $12,000,000, plus a $5,000,000 permanent policy on her own life that she owns. Her children are the beneficiaries.

Dana's children receive $5,000,000 tax-free from the insurer either way, but in the first case the estate may need to pay about $800,000 to the IRS, which is due nine months after death. Insurance owned outside the estate can also supply the cash to pay it; see estate liquidity: paying taxes and debts without a fire sale. Her actual numbers would also account for deductions, debts and any state tax.

Don't forget the state level

Some states impose their own estate or inheritance tax with thresholds far below the federal exemption, so a family can owe state tax with no federal liability. The rules vary and change; see state estate and inheritance taxes and life insurance and the guide for your state.

What to do this year

1. Add up your estate: home, retirement accounts, investments, business interests and the death benefits of every policy you own.
2. Run the estate tax exposure check to see whether you are near $15,000,000 (or $30,000,000 for a couple with portability).
3. List who owns each policy. If you are the owner and the insured, you hold the incidents of ownership.
4. If exposure is real, take the list to an estate attorney or CPA before moving any policy, since transfers have gift tax, transfer-for-value and three-year consequences. This is the point at which professional advice earns its fee.

Key takeaways

• Death benefits are included in the insured's gross estate if payable to the estate or if the insured held incidents of ownership (IRC §2042).
• The 2026 federal exclusion is $15,000,000 per person, with a 40% top rate on the excess; most estates owe nothing.
• Moving a policy to a trust or another owner can remove proceeds from the estate, but a transfer within three years of death is brought back in by §2035.
• Marital deduction and portability usually defer or eliminate tax at the first death.
• State estate taxes can apply at much lower amounts than the federal tax.