Before you unwind a policy purchased to pay estate tax, check your state — because the federal exemption is now high enough that most families are exempt, while a dozen-odd states impose their own estate or inheritance tax at thresholds a fraction of the federal number. The most common planning error of the last decade is dismantling federal-focused planning without checking whether a state tax quietly took its place.
The federal picture moved fast. The Tax Cuts and Jobs Act of 2017 roughly doubled the basic exclusion amount for 2018 through 2025, and legislation enacted in 2025 set it at $15 million per person beginning in 2026, indexed for inflation — confirm the current figure with the IRS, as these numbers have changed repeatedly and could change again. Portability lets a surviving spouse use a deceased spouse’s unused exclusion if a timely Form 706 is filed, effectively doubling the shelter for many married couples.
This page walks through how to re-test whether the policy is still doing a job, the alternatives if it is not, and the several reasons a policy bought for estate tax is often worth keeping anyway. Pine Lake Life Solutions offers a free, no-obligation policy review and is not a law firm or tax advisor.
In This Article
Re-Test the Original Assumption
The policy was bought against a projection. Redo the projection with current numbers. Total the taxable estate: real property, retirement accounts, business interests, taxable investments, and any life insurance the decedent would hold incidents of ownership over under IRC section 2042 — a policy owned personally counts, a properly structured trust-owned policy generally does not.
Then compare against the current federal exclusion, remembering portability for a married couple with a timely filed Form 706. Then, separately, compare against the state threshold where the client is domiciled and where they own real property. Several states levy estate taxes at thresholds well below the federal level, and a few impose inheritance taxes on transfers to non-lineal heirs regardless of estate size. Confirm current state figures directly, as several states adjust annually.
Only after both tests come back clean is it fair to say the policy’s original purpose has expired.
The Reasons the Policy May Still Be Earning Its Keep
Estate tax was the headline purpose, but these policies frequently do other work:
- Liquidity. An estate heavy in real estate, farmland, or a closely held business may need cash at death regardless of tax — to pay debts, fund a buy-sell agreement, or avoid a forced sale.
- Equalization. One child inherits the business; the others need an equivalent value. Insurance is the classic funding source.
- Income replacement for a surviving spouse. Often the real reason, hiding behind the tax rationale.
- Special needs funding. A policy feeding a special needs trust for a disabled child should almost never be liquidated without a specialist’s involvement.
- Charitable intent. A death benefit directed to a charity accomplishes something a lower tax bill does not.
- Legislative risk. Exemption levels are a policy choice and have moved repeatedly. A family whose estate sits near the threshold may prefer to keep coverage rather than bet on the law staying put.
If It Truly Is Unneeded: The Option Set
Keep paying. Defensible when the premium is small relative to the estate and any of the purposes above still apply.
Reduce the face amount. Right-size rather than eliminate. Keeps some liquidity at a lower cost.
Reduced paid-up. Ends premiums permanently, retains a smaller guaranteed death benefit, produces no cash.
1035 exchange. Move cash value tax-free into a more efficient life contract, or — under the Pension Protection Act provisions effective in 2010 — into a qualifying long-term care contract. New underwriting typically applies, which is often the binding constraint.
Charitable gift of the policy. Donating a policy to a qualified charity can produce an income tax deduction, generally limited to the lesser of basis or fair market value, with substantiation requirements including a qualified appraisal above certain thresholds. Discuss with a CPA.
Surrender. Cash surrender value, fast and final, usually the lowest number.
Life settlement. Sale to a third-party buyer. GAO-10-775 found sellers typically received about 10% to 35% of face value, roughly four to eight times cash surrender value. Buyers generally want a death benefit of about $100,000 or more on a senior or health-impaired insured, and the process takes roughly 60 to 120 days.
| Test | What to Check | Implication if It Fails |
|---|---|---|
| Federal exclusion | Estate value vs. current basic exclusion amount, plus portability | Federal need for the policy is gone |
| State estate or inheritance tax | Domicile state and states where real property is owned | Policy may still be doing real work |
| Liquidity | Illiquid assets: business, farmland, real estate | Keep coverage regardless of tax |
| Equalization | One heir inherits the business, others do not | Keep coverage |
| Special needs | Trust funded by the death benefit | Do not liquidate without a specialist |
| Replaceability | Insured’s current health and no-lapse guarantee status | Coverage may be irreplaceable at any price |
Special Care When the Policy Sits in an ILIT
Most estate-tax policies are owned by an irrevocable life insurance trust, which means the grantor cannot decide unilaterally. The trustee acts, subject to the trust document and state law, and owes duties of prudence and impartiality to the beneficiaries.
Practical implications: the trustee decides whether to keep, restructure, distribute, sell, or surrender; the insured must consent and sign a HIPAA authorization for any sale; beneficiary notice or consent is often required; and a buyer will want a certification of trust establishing authority. If the beneficiaries would prefer cash now to a death benefit later, that preference should be documented, not assumed.
Distributing the policy out of the trust deserves particular caution. If the insured is also a beneficiary and receives the policy, incidents of ownership under section 2042 may be restored and the death benefit could return to the taxable estate — the exact outcome the trust was built to prevent. The transfer-for-value rule of IRC section 101(a)(2) is the other trap to clear with a tax advisor.
The Tax Result of a Sale
Three layers. Proceeds up to the policy’s adjusted basis are generally a return of capital. Amounts above basis and up to the cash surrender value are typically ordinary income. Amounts above cash surrender value are generally capital gain. The Tax Cuts and Jobs Act of 2017 changed the basis computation by eliminating the cost-of-insurance reduction that earlier guidance had required, and the IRS reflected that change in Revenue Ruling 2020-5.
Transactions are reported to the IRS under IRC section 6050Y, with information returns issued to the seller and the carrier. A different regime applies when the insured is terminally or chronically ill under IRC section 101(g), where viatical treatment can make proceeds income-tax-free. Have a CPA run the numbers before signing, not after.
When Keeping Is Clearly Right
Keep the policy if a state estate or inheritance tax applies at your level of wealth. Keep it if the estate is illiquid — a farm, a building, a closely held company — because the tax question and the liquidity question are different questions. Keep it if a special needs trust depends on it. Keep it if the insured’s health has declined to the point that replacement coverage is unavailable or unaffordable, which converts an ordinary policy into an irreplaceable asset.
Keep it, too, if the contract is a guaranteed universal life policy with a no-lapse guarantee issued under older mortality and interest assumptions. Those guarantees are frequently worth far more than the cash value suggests and cannot be repurchased at today’s pricing.
If, after all of that, the coverage is genuinely unneeded, find out what it is worth before surrendering it. A screening review requires only the policy cover page — the insurer, policy number, face amount, and issue date — and takes days. Pine Lake Life Solutions provides it free at (305) 209-7183 and works alongside your own counsel and CPA.
A Review Checklist
Update the estate inventory with current values. Confirm the federal exclusion figure for the current year and whether portability was preserved by a timely Form 706 after any first death. Check the estate tax rules of every state where the family is domiciled or owns real property. Identify every non-tax purpose the policy might still serve. Ask the carrier for an in-force illustration at both guaranteed and current assumptions and confirm no-lapse guarantee status. If the policy is trust-owned, ask the trustee to document the analysis.
Then decide deliberately. Most families in this situation discover the policy is worth keeping in some reduced form; a minority find it is genuinely surplus. Both answers are fine. Drifting for another decade while premiums leave the account is not.
Frequently Asked Questions
What is the federal estate tax exemption in 2026?
Legislation enacted in 2025 set the basic exclusion amount at $15 million per person beginning in 2026, indexed for inflation. Confirm the current figure with the IRS or your tax advisor, since these amounts have changed repeatedly. Portability can let a surviving spouse use a deceased spouse’s unused exclusion if Form 706 was timely filed.
My estate is under the federal exemption. Should I drop the policy?
Not until you check your state. Several states impose their own estate or inheritance tax at thresholds well below the federal level, and a few tax transfers to non-lineal heirs regardless of size. Also test whether the policy is providing liquidity, equalization, or special needs funding rather than tax payment.
Can the grantor just cancel an ILIT-owned policy?
No. The trustee owns the policy and makes the decision, subject to the trust document and state law, owing duties of prudence and impartiality to beneficiaries. Any sale also requires the insured’s written consent and a HIPAA authorization. A buyer will want a certification of trust establishing the trustee’s authority.
Is distributing the policy out of the trust a good idea?
It can create problems. If the insured is also a beneficiary and receives the policy, incidents of ownership under IRC section 2042 may be restored and the death benefit could re-enter the taxable estate. The transfer-for-value rule of section 101(a)(2) is a second trap. Get tax counsel’s review before any distribution.
How are life settlement proceeds taxed?
Generally, amounts up to basis are a return of capital, amounts up to cash surrender value are ordinary income, and amounts above that are capital gain. The Tax Cuts and Jobs Act of 2017 changed the basis calculation, as reflected in Revenue Ruling 2020-5, and transactions are reported under IRC section 6050Y. Have a CPA model it before signing.
Can I donate the policy to charity instead?
Yes, and it can produce an income tax deduction, generally limited to the lesser of basis or fair market value, with substantiation rules including a qualified appraisal above certain thresholds. It also accomplishes a charitable purpose the tax savings alone would not. Discuss the deduction mechanics with a CPA before transferring ownership.
What if the insured’s health has declined?
That usually argues for keeping the coverage, because replacement would be unavailable or unaffordable. It also means the secondary market would likely value the policy more highly if the family did decide to sell. Both facts point to getting a documented valuation before making any irreversible decision.
What does a free policy review involve?
Send the policy cover page, showing the insurer, policy number, face amount, and issue date, with the owner’s or trustee’s authorization. The screening takes days and tells you whether the secondary market is likely interested. Call (305) 209-7183; there is no obligation either way.
Find out what your policy is worth — free, confidential, no obligation.
A 15-minute educational review covers your eligibility, every alternative, and a realistic view of what each path would net you.
Related Reading
- Estate Plan Changed
- Sell Ilit Trust Owned Policy
- Ilit Termination Policy Disposition
- Life Settlement Vs Ilit Planning
- Life Settlement Vs Charitable Gift Of Policy
- Are Life Settlement Proceeds Taxable
- Tcja Life Settlement Tax Rules Explained
- Trustee Duty Underperforming Policy
- What Is A No Lapse Guarantee
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.