Life Insurance policies can be an effective way to plan for taxes, especially permanent policies, also known as whole life insurance.
First, a brief review of the two broad categories of life insurance: term and permanent. Term policies provide a death benefit if you die within a specified term; a 20-year policy bought when you’re 35 will pay a death benefit if you pass before 55. If you outlive the term, there is no benefit. Permanent or whole policies, on the other hand, pay a death benefit no matter when you pass away, as long as you are paid up on premiums, but such policies also accrue a “cash value” over time, effectively serving as an alternate investment vehicle.
Permanent policies are usually the choice for tax planning purposes. Here’s a commonplace approach: establish an irrevocable trust to own the policy, typically an ILIT or a SLAT. Gift cash to the trust every year using the annual gift exclusion, and the trust will then use the cash to pay premiums on a whole life insurance policy on you (and/or your spouse, depending on the policy). Upon your death, the paid benefit will be outside of your estate. This not only avoids estate tax on that asset; it can also provide liquidity for heirs to pay estate taxes on illiquid assets such as real estate or a family business.
Such a policy offers two additional benefits: it’s an income-tax-free savings and investment vehicle outside of your taxable estate (if set up correctly), and it accrues a cash value over time.