Posted On: August 4th 2016
Abstract: Life insurance can provide peace of mind, but it’s important to not own the policy at death. Why? The policy’s proceeds will be included in the taxable estate and may be subject to estate taxes. To avoid this result, a common estate planning strategy is to set up an irrevocable life insurance trust (ILIT) to hold the policy. This article describes the tax benefits of an ILIT, along with some drawbacks.
If you’re concerned about your family’s financial well-being after you’re gone, life insurance can provide peace of mind. However, make certain that you don’t own the policy at death. Why? The policy’s proceeds will be included in your taxable estate and may be subject to estate taxes. To avoid this result, a common estate planning strategy is to set up an irrevocable life insurance trust (ILIT) to hold the policy.
“Use an ILIT to shield life insurance proceeds from estate tax”
Contributing an existing life insurance policy to an ILIT constitutes a taxable gift to the trust beneficiaries of the policy’s fair market value (which generally approximates its cash value). With the combined gift and estate tax exemption currently at $5.45 million, now may be a good time to make such a gift.
Keep in mind that future ILIT contributions to cover premium payments will be taxable gifts. You may, however, be able to apply your annual gift tax exclusion (currently $14,000; $28,000 for married couples splitting gifts) to reduce or eliminate the tax — provided the ILIT is structured appropriately and certain other requirements are met.
To remove a life insurance policy from your taxable estate, simply transferring the policy to an ILIT isn’t enough. You must also relinquish all “incidents of ownership,” such as the power to change or add beneficiaries; to assign, surrender or cancel the policy; to borrow against the policy’s cash value; or to pledge the policy as security for a loan.
If you retain any incidents of ownership, the insurance proceeds will still be included in your estate. And they may be subject to estate taxes, depending on the size of your estate and your available estate tax exemption.
Also, be aware of the “three-year rule,” under which the proceeds are pulled back into your taxable estate if you die within three years after transferring an existing policy to an ILIT. In light of this rule, the safest strategy is to establish the ILIT first and have it acquire a new insurance policy on your life. But if you already own a policy, the sooner you transfer it to an ILIT, the greater the chances that you’ll successfully remove it from your estate.
An ILIT offers significant tax benefits, but it also has some significant limitations. As mentioned, after you transfer a policy to the trust, you can no longer change or add beneficiaries; assign, surrender or cancel the policy; or borrow against or withdraw from the policy’s cash value. In addition, you’re not allowed to alter the ILIT’s terms or act as trustee.
Nevertheless, there are some techniques available to build flexibility into an ILIT. For example, you can design the trust to adapt to changing circumstances, provide that children or grandchildren born after you establish the trust be automatically added as beneficiaries, and give the trustee the power to remove beneficiaries under certain circumstances (such as removing your daughter-in-law if she and your son divorce).
You can also establish conditions for distributing funds from the ILIT. For example, you might instruct the trustee to withhold funds from a beneficiary who drops out of school or develops a substance abuse problem.
Another strategy is to appoint a “trust protector.” A trust protector is a sort of super-trustee who has the power to remove the trustee, amend the trust or take other actions to ensure that the ILIT achieves your objectives in light of changing laws or circumstances.
A life insurance policy can protect your family’s financial future. Using an ILIT can help ensure the policy works as you intend by shielding the proceeds from hefty estate taxes.