Would you be surprised to learn that the death proceeds of your life insurance may be subject to federal estate taxation? Many believe that life insurance escapes estate taxes and passes to their loved ones without obligation. Even though they may have a small estate, their families may find that they owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a substantial death benefit. Life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax.
An Irrevocable Life Insurance Trust (ILIT) is a vehicle for keeping life insurance proceeds out of the estate of the insured individual. An ILIT should be considered when:
- an individual’s gross estate before life insurance is over the estate tax exclusion ($5,490,000 in 2017), or
- if life insurance will put the individual over the estate tax exclusion, or
- if an individual’s net worth is expected to exceed the estate tax exclusion in the future.
An ILIT should also be considered for a married couple if life insurance will put them over the married couple’s estate tax exclusion, which is currently $10,980,000. The estate caught unprepared may pay up to 35% of life insurance proceeds to taxes.
An irrevocable trust will own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own “extremes,” and often against their creditors. Moreover, the trust also provides reliable management for the trust assets.
An ILIT is set up by a grantor who transfers funds into the trust which are then used to purchase life insurance on the grantor. A trust can buy insurance outright on a grantor or the grantor can transfer existing policies into the trust. If an existing policy is transferred into the trust, the policy proceeds are excludable from the grantor’s taxable estate only if the policy has been in trust for three years prior to the grantor’s death. The value of the gift to the trust is the value of the policy gifted on the date of transfer. This value is determined by the insurance company. Also, the transfer of an existing policy can trigger a taxable event should policy loans exceed total premiums paid. In other words, you contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift exclusion, so you won’t have to pay gift tax on the contributions. As a side, the current gift exclusion is $14,000.00 per year per donee (recipient) without any gift tax implication.
There are two main reasons for having large life insurance policies: 1) to provide for one’s family if the primary earner in a family dies during working years, and 2) to provide liquidity to pay estate taxes in the case of a non-liquid estate. The amount of life insurance that a trust should own on the grantor and the type of policy the trust should own depend on the facts specific to the grantor’s estate.
An ILIT is a highly technical trust document that is controlled not only by trust law, but also by various regulations, rulings, court cases, and the Internal Revenue Code. The ILIT is irrevocable, meaning you cannot change the terms once it has been signed, although some flexibility can be written into the document. Moreover, the ILIT cannot be payable to your estate or to your revocable living trust, as your ability during lifetime to change your will or trust would result in your ability to change the beneficial enjoyment of the policy proceeds, thus reverting the policy back into your taxable estate. Usually, the trust agreement provides that, after a contribution is made, each beneficiary will be notified of their right of withdrawal. After the expiration of the withdrawal period (usually not less than 30 days), the trustee can use the contribution to pay the premium of a life insurance policy. The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee’s discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust and permits the trust to be terminated if desired despite its being irrevocable. The beneficiary is given certain beneficial interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive the principal. On the death of your beneficiary, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.
You, and sometimes your spouse, cannot serve as trustee of the ILIT. The trustee can be almost anyone else, such as a parent, a sibling, a friend, your attorney, certain law firms, or even a bank – provided they are not a beneficiary of the Trust. The IRS is notorious for challenging ILITs when all requirements are not met. Therefore, seek out a well-seasoned attorney to assist in the preparation of the documents. Proper administration of the ILIT is also critical and therefore there is much to consider even after the Trust is drafted. If your individual or marital estate does not currently exceed, nor has the possibility of exceeding in the near future, the exemption amount(s) then you may not need an ILIT or even an expensive life insurance plan. Consider your estate planning needs with care. Do not be oversold on planning vehicles. Evaluate your estate planning needs often as to determine whether changing circumstances require modification of your Will and other important legacy documents.