As our population’s median age increases with the Baby Boomers slipping into retirement, the necessity of proper estate planning becomes even more imperative. One aspect of this crucial agenda is sometimes ignored or not fully recognized as a liability when the numbers of an estate are crunched. A life insurance policy with a substantial death benefit can turn a modest estate into one that the family of the deceased must now pay hundreds of thousands of dollars in estate taxes. Although life insurance proceeds are not subject to federal income tax, they are considered part of your taxable estate and thus are subject to federal estate tax. This is because, if the policy owner can withdraw the cash value and change the beneficiary, then the policy owner will be deemed to have incidents of ownership over the proceeds and the IRS and, if applicable, state taxing authorities, can then tax the proceeds at death.
If you poses a $3,000,000 term life insurance policy at the time of your demise, then the insurance proceeds collected by your estate will already use up more than half of your $5,340,000 exemption from federal estate taxes in 2014. The result is even worse if your state collects estate taxes, since most state, “estate tax exemptions” remain at or below $1,000,000.
The solution to the problem of having your life insurance proceeds taxed at death is to establish an Irrevocable Life Insurance Trust, or ILIT. A properly drafted ILIT will prevent the insurance proceeds from being taxed in your estate as well as the estate of your surviving spouse.
An ILIT is a type of irrevocable trust that is specifically designed to hold and own life insurance policies on your life. Once the ILIT has been set up, you will then have to transfer ownership of your life insurance policies to the Trustee of the ILIT. You can contribute cash to the trust to be used by the trustee, which in turn they use to make the premium payments on the life insurance policies. If the trust is properly drafted, the contributions that you make to the trust for the premium payments will qualify for the annual gift tax exclusion, so you won’t have to pay gift tax on the contributions made to the ILIT.
While you can’t be a Trustee of the ILIT, otherwise you’ll be deemed to have incidents of ownership in the life insurance, your spouse and or children can be Trustees. Once you’ve transferred ownership of the life insurance to the Trustee of the ILIT, you will have given up all of your incidents of ownership over the policies. Since you’ll no longer own the policies, the proceeds can’t be taxed in your estate when you die.
One important factor in establishing an Irrevocable Life Insurance Trust is that the life insurance policy must be transferred to the trust at least three years before the death of the insured. To get around this rule, a new policy can be taken out with a spouse as the owner and then placed in the trust.
As an irrevocable trust, changes can only be made by beneficiaries; the owner gives up all control to the trustee. If the size of the taxable estate is below the maximum exclusion figure, it is generally not necessary to set up an insurance trust; in this case the life insurance will be included in the decedent’s taxable estate.
If you own a life insurance policy with a significant death benefit, an Irrevocable Life Insurance Trust may be of substantial benefit to you.
All in all, drafting an Irrevocable Life Insurance Trust may sound overwhelming, but garvey & garvey, llc CPAs can easily assist in establishing a plan that is appropriate, so that there are no unwelcome surprises from your estate.