Life insurance is an asset that you can include in your estate. If the payout exceeds federal or state estate tax exclusion limit, it can trigger an expensive estate tax bill. This is why you might want to think about an irrevocable trust for life insurance.
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It is possible to believe that life insurance does not have a tax. The “no tax on your life insurance” myth is partially true. Income tax is not applicable to life insurance. The sum of the decedent’s life insurance policy is exempt from income tax.
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If the estate is large enough, however, any life insurance proceeds and any federal or state estate taxes could apply. Let’s take, for example, a $1,000,000 life insurance policy. That policy is considered an asset by the IRS, much like an investment portfolio of $1 million. The IRS taxes the policy as an asset upon your death. This estate tax is due upon your death and can be quite substantial.
How can you avoid your life insurance proceeds being included in your estate, and thus potentially subject to estate tax? You can make an irrevocable trust for your life insurance (ILIT) by naming that trust as the owner. This will remove that asset from your estate. The proceeds of your life insurance policy will be passed to your heirs upon your death. They will not only receive income tax-free, but also estate tax-free.
An ILIT candidate? An ILIT can save up to 40% on federal estate taxes for families whose estate exceeds the federal “application exemption amount”. This is the $11.7 million for singles and $23.4 millions for couples. The legal fees and complexity involved in setting up an ILIT are worth it. Remember that 12 states and the District of Columbia have their own estate taxes. Their exclusion amounts could be lower than the federal.
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Another benefit is that an ILIT can help to avoid tax on the estates of both spouses. Life insurance proceeds can be kept in trust for the benefit and protection of the spouse who is surviving. The proceeds of the death benefit will not be included in the estate. However, they will pass tax-free to your family and your grandchildren as an ILIT in a multigenerational trust.
You should be aware that the IRS closely examines ILITs. To ensure your ILIT passes IRS inspection you will need to:
You can transfer any polices that you own to the ILIT through an “absolute assignation” or “change in ownership” form.
All ownership rights must be relinquished to the trust. It is not as easy as you might think. You can even be charged with maintaining an ownership interest in a life insurance policy, even though you have never held title to it. You must:
All ownership rights, including the right of changing beneficiaries and borrowing from cash, as well as the right to make premium payments, must be given up
To create separate funds from which premiums will be paid, enter into an annual cash division agreement. This ensures that no one is misled about who the owner/payor is.
You must maintain a change in ownership of an existing policy for at most three years after the death of the insured. This means that you must live for at least three consecutive years after transferring your insurance policy to the trust. If you don’t, the proceeds of the transfer will be subject to taxation in your estate just like if the policy were still yours.
The bottom line is that your heirs won’t pay income tax on any proceeds of life insurance they receive. However, if they inherit a large estate, they will have to pay estate taxes on the policy. This applies unless an ILIT was set up at least three years prior to your death. Although ILITs are a good option for some families, they can also save a lot of money. It is best to hire a professional to help you design a trust that meets IRS standards.
The Act will expire on December 31, 2025. After that, the amount will be adjusted to the $5 million exemption.