A life insurance death benefit generally passes to the beneficiary free of income tax. That part is well known. The harder question comes next: what will your kids do with the money, and can they keep it growing tax-free for their own children?
Here's the problem I'm working on with my daughters. Say you live to 90. Your kids will be past 50 when they get the money. By then they might not qualify for new life insurance, or the cost might be steep, which means their options for passing the money on shrink.
The approach is to build room for it into a policy that is started on the child today, while they're young and healthy. A child can generally qualify for up to half of a parent's death benefit. So a parent with $2 million of coverage can support a $1 million policy on a child.
Here are my numbers on one of my daughters, who is 16. The policy is an indexed universal life with a $1 million increasing death benefit. The MEC limit, which is the most the policy will let you pay in a year without losing its tax treatment, is $26,862 a year. The minimum premium is just over $1,800. I plan to put in about $6,000. That leaves roughly $20,000 of unused funding room each year.
In this kind of policy the unused room carries forward. After 49 years, the projection shows about $1.8 million of cash value, even though I only paid in $6,000 a year. Close to $1 million of unused funding room has built up. When she receives a tax-free death benefit from my policy, she can put a big piece of it into hers, where it grows tax-deferred, she can borrow from it during her life, and it passes to her children income-tax-free. At that point she can start a policy on her own kids, and the cycle continues.
There are caveats. Funding room carries forward in this design, and not every policy or carrier works that way. Whole life companies tend to limit how much extra you can add. The projections assume the index credits illustrated, which aren't guaranteed, and the policy's insurance charges come out every year. Estate tax is a separate subject, covered in whether a death benefit counts as part of your estate.
The illustration itself is on screen in a video on using an IUL as a tax-free generational wealth tool. I'm a licensed insurance broker, not an attorney or CPA, so bring your estate attorney in before you set up trusts or name the next generation.
If you'd like to start with the basics, a quick beneficiary checkup tells you who gets what today.