Types

• There are two types of taxes that your beneficiaries must know about in regard to life insurance policies. First, life insurance policies are passed to beneficiaries on an income tax-free basis. This means the proceeds are not taxed as income. But, they are not taxed as capital gains either. The only tax that your beneficiaries must worry about is the estate tax.
  
  

Significance

• The death benefit of a life insurance policy is included in the calculation of estate taxes. This means that whatever death benefit is received by your heirs must be included in your estate when calculating estate taxes. Unless current estate tax laws change (as of 2010), your heirs will be responsible for paying up to 55 percent on an estate valued at more than $1 million. Only dollar amounts in excess of $1 million will be subject to the estate tax.
  
  

Prevention

• To prevent your heirs from paying the estate tax, you must transfer your life insurance policy to an irrevocable life insurance trust prior to your death. The life insurance trust removes the life insurance policy from your estate and allows the death benefit to be passed on to your heirs without paying any tax on any of the proceeds.
  
  

Consideration

• When moving a life insurance policy to an irrevocable life insurance trust, you lose control over the policy. You cannot have access to any cash values in the policy, and you may not change beneficiaries on the policy. You cannot have any resemblance of control over the policy at all. So, before making this transfer, you should be confident that you won't need to make any changes to your life insurance, and that you don't need the policy for some other purpose.