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Life insurance can be a cost effective and income and estate tax free means of providing for the payment of estate taxes, as well as for the financial support of your surviving spouse and children. While life insurance proceeds are normally taxable in the estate of the insured, if the insured does not own or otherwise have any incidents of ownership in the policy, the proceeds will be paid to the named beneficiary, free of estate tax. Further, life insurance proceeds, except in certain limited circumstances, is not taxable for income tax purposes.
In order to obtain the above treatment, the insurance policy, if already existing, should be transferred to either an irrevocable life insurance trust created by the insured, or to a trusted person who is not the insured. However, the best method of assuring that the policy proceeds will not be included in your estate would be to create an irrevocable life insurance trust and have the trust apply for a new insurance policy. This would avoid the three year throwback rule in which the policy, despite not being owned by the insured, will be included in the insured's estate for federal estate purposes if the insured dies within three years of creating the trust.