Why people use life insurance to equalize inheritances
Life insurance is commonly used to equalize inheritances because it creates an immediately available, predictable cash payment at death. When an estate contains illiquid or high-value assets (a family business, a home, a farm), dividing those assets equally on paper does not always create equal outcomes in cash or ongoing management responsibility. A life insurance death benefit lets you make a cash transfer to one or more heirs to balance the total value each receives.
In my practice advising clients for more than 15 years, I’ve seen life insurance resolve two recurring problems: (1) a single heir assumes an illiquid asset and the others need cash to receive comparable value, and (2) blended-family dynamics where parents want to provide for a surviving spouse and also protect children from an earlier marriage. The solution can be simple (a term or permanent policy naming a child as beneficiary) or more complex (an irrevocable life insurance trust).
Authoritative guidance on life insurance tax treatment and estate planning practices is available from the IRS and the CFPB; for example, the IRS explains general tax rules for life insurance proceeds and estate inclusion (see: https://www.irs.gov/businesses/small-businesses-self-employed/life-insurance-proceeds) and the Consumer Financial Protection Bureau offers practical estate-planning steps (https://www.consumerfinance.gov/consumer-tools/estate-planning/).
Common ways to use life insurance to equalize inheritances
- Policy designated to a specific heir: Buy a policy and name the child who won’t receive the house as beneficiary for the amount that evens out the distribution.
- Policy owned by an estate or trust: Signature, ownership, and beneficiary choices affect probate, tax treatment, and control—more below.
- Cross-purchase or buy-sell funding for a business: If one child buys the business interest, life insurance proceeds can compensate other siblings.
- Second-to-die (survivorship) policies: Often used by married couples concerned with estate tax planning; proceeds pay at second death and can be sized to equalize between surviving family members and descendants.
Step-by-step approach (practical checklist)
- Inventory and value assets: Get current appraisals for real estate, businesses, and retirement accounts. Use fair-market value; update valuations periodically.
- Calculate desired equalization: Decide whether you want strictly equal dollar shares or a more flexible fairness standard (for example, accounting for nonfinancial contributions such as caregiving).
- Determine shortfalls and liquidity needs: Identify who needs cash to be equal and how much. Consider taxes, fees, and probate costs that will reduce net shares.
- Choose policy type and ownership: Term (cheaper, limited years) vs permanent (cash value, lifetime coverage) and decide whether the insured owns the policy or transfers it to a trust or other owner.
- Coordinate with your will/trust and beneficiary designations: Make beneficiary designations explicit and consistent with estate documents to avoid surprises.
- Update regularly: Revisit on major life changes—marriage, divorce, new child, selling a business, or retirement.
Example calculation
Parents own a home worth $400,000 and want each child to receive $400,000 in total value. Child A will inherit the home; to equalize, parents take a $400,000 life insurance policy naming Child B as beneficiary. If Child A receives the home at $400,000 and Child B receives the $400,000 death benefit, the heirs are equal in nominal dollars. Adjust for taxes, fees, and mortgage balances when calculating the needed policy amount.
Note: While life insurance death benefits are generally excluded from the beneficiary’s gross income (IRC §101(a)), life insurance may be included in the decedent’s estate for estate tax purposes if the decedent retained incidents of ownership. If estate-tax exposure is a concern, speak with a tax or estate attorney and consider strategies described below (IRS and CFPB links above).
Ownership and tax traps to watch for
- Probate vs non‑probate: A policy that names a beneficiary typically pays outside probate, giving heirs immediate liquidity. But if the beneficiary is the estate, the proceeds do pass through probate.
- Estate inclusion: If the decedent owned the policy or retained rights (ability to change beneficiaries, borrow against it, or surrender it), the policy’s proceeds may be included in the gross estate, potentially subjecting them to estate tax. To keep proceeds out of the estate, many clients use an irrevocable life insurance trust (ILIT); however, transfers into an ILIT within three years of death may still be pulled back into the estate under the IRS three‑year rule (IRC §2035). See professional counsel before transferring.
- Income tax: In most cases, a beneficiary does not pay federal income tax on the death benefit. However, if proceeds are left with the insurer and interest is paid, the interest portion is taxable.
Irrevocable Life Insurance Trusts (ILITs): when and why to use one
An ILIT can remove life insurance proceeds from the insured’s taxable estate and control distribution to beneficiaries (e.g., hold cash to equalize shares or fund buyouts). Typical characteristics:
- The trust owns the policy (not the insured).
- The trustee manages premium payments and pays beneficiaries according to trust terms.
- Properly drafted ILITs avoid estate inclusion if transfers were made more than three years before death and no incidents of ownership are retained).
ILITs require careful drafting, funding, and administration. In my experience, ILITs are most useful for clients with larger estates near or above the federal estate-tax exemption or clients who want to protect proceeds from creditors or divorcing spouses.
Design considerations: term vs permanent, single-life vs survivorship
- Term life: Cost-effective for a specific need (e.g., until a mortgage is paid or until children are grown). Good when you want a temporary guarantee to equalize a known shortfall.
- Permanent life (whole or universal): Costlier but provides lifetime coverage and a death benefit that won’t expire. Useful when equalization is part of a long-term legacy plan.
- Survivorship/second-to-die policies: Pay on the second death of two insureds and are often used to provide cash for estate taxes or to equalize between next-generation heirs after both parents die.
Practical drafting tips to reduce conflict
- Be explicit in estate documents: State that the purpose of the policy is to equalize inheritances and specify how the numbers were calculated. Clear intent reduces the risk of disputes.
- Consider a memorandum or letter of instruction attached to the will or trust explaining your rationale (not legally binding but helpful).
- Use separate trustees or corporate trustees for sensitive situations: A neutral trustee can reduce family friction when one heir receives the policy proceeds.
- Coordinate beneficiary designations with your will and trusts: Beneficiary designations override wills for life insurance; ensure they match your overall plan.
Common mistakes and how to avoid them
- Failing to update beneficiary designations after life events (marriage, death, divorce).
- Assuming life insurance automatically avoids estate tax—ownership matters.
- Over- or under-insuring because of outdated asset values. Reappraise major assets every 3–5 years.
- Naming a minor as a beneficiary without planning to manage the money (use a trust or custodian account instead).
When life insurance isn’t the best tool
If the goal is to equalize nonfinancial contributions (caregiving, family leadership) or to share sentimental items, life insurance may not address perceived fairness. Other tools include dividing assets differently, using trusts for staggered distributions, or arranging buyouts funded from estate liquidity.
Coordination with broader estate planning (links and resources)
Life insurance equalization works best as part of a comprehensive plan. See our primer on broader estate planning principles and documents (Estate Planning: https://finhelp.io/glossary/estate-planning/). If estate-tax exposure or trust drafting is a concern, review our estate tax planning resources (Estate Tax Planning: https://finhelp.io/glossary/estate-tax-planning/) and trust requirements (Understanding Trusts and Estate Tax Filing Requirements: https://finhelp.io/glossary/understanding-trusts-and-estate-tax-filing-requirements/).
For blended families, consider approaches and language that reduce conflict and clarify intent (Blended-Family Estate Solutions: Fairness without Conflict: https://finhelp.io/glossary/blended-family-estate-solutions-fairness-without-conflict/).
When to call a professional
- You have a large or complex estate, a business, or a blended family.
- You want to use an ILIT or face possible estate-tax exposure.
- You need help valuing illiquid assets or modeling insurance funding scenarios.
Consult a qualified estate planning attorney and a licensed life insurance agent. Tax and trust drafting require state-specific expertise; this article is educational and not a substitute for personalized legal or tax advice.
Quick checklist before you buy a policy to equalize inheritances
- Complete an asset inventory and valuation.
- Decide target equalized dollar amounts.
- Choose policy size and type consistent with your goals and budget.
- Confirm ownership and beneficiary designations align with estate documents.
- Consider an ILIT if estate inclusion is a concern.
- Document your intent in the will or trust.
- Review annually or after major life events.
Final takeaways
Life insurance is a flexible, cost-effective tool to equalize inheritances when used thoughtfully and coordinated with your overall estate plan. The right ownership structure and clear documentation—paired with professional advice—prevent tax surprises, probate delays, and family disputes. For practical next steps, gather valuations, meet with an estate attorney, and discuss policy designs with a licensed agent.
Disclaimer: This article is educational and does not constitute legal, tax, or investment advice. Consult a licensed attorney, tax advisor, or insurance professional for recommendations tailored to your situation.