Final answer:
Life insurance can be used to pay state inheritance and federal estate taxes to ensure the preservation of estate assets, a strategy known as estate liquidity. This helps beneficiaries to cover the tax burden without selling estate assets.
Step-by-step explanation:
Life insurance can be used to pay state inheritance taxes and federal estate taxes, often preventing the need to sell off assets from the estate. This strategy is known as liquidity planning or using life insurance for estate liquidity. By having a life insurance policy, the proceeds from the policy can be used by the beneficiaries to cover these taxes. This ensures that assets such as family homes, businesses, or heirlooms can remain within the family without the necessity of liquidating them to meet tax obligations.
The estate and gift tax in the United States functions to tax the transfer of assets from one generation to another, whether it be after death or during life as gifts. While the estate tax only impacts those leaving large inheritances above a certain threshold, it can still represent a significant tax burden. Life insurance is a common financial tool used to provide liquid funds to settle these tax liabilities.