Do you own a life insurance policy? If so, the proceeds from the policy will be included in your taxable estate when you die.
Strategy: Set up an irrevocable life insurance trust (ILIT). Then transfer ownership of the policy to the ILIT. Accordingly, the life insurance proceeds are removed from your estate, often saving your family tens or even hundreds of thousands of estate tax dollars.
Typically, this technique is used for an existing life insurance policy, but it also works if you arrange to have the trust purchase a new policy on your life (or the lives of you and your spouse).
The ILIT has been around for years, but it’s enjoying a revival of late, due to certain provisions in the new American Taxpayer Relief Act of 2012 (ATRA).
Here’s the whole story: Life insurance proceeds paid out from a policy where you are the insured are exempt from estate tax only if you don’t possess any “incidents of ownership” in the policy. For example, you’re treated as having incidents of ownership if you have the right (without necessarily exercising it) to:
- Designate or change the beneficiary or beneficiaries of the policy
- Borrow against the policy or pledge any cash reserve
- Surrender, convert or cancel the policy
- Select a payment option for the beneficiary or beneficiaries.
Here’s how it works: You establish the trust and transfer complete ownership of the policy to it. At the same time, you designate the trustee to handle the administrative duties. It might be a family member, friend or a pro. If you acquire any additional life insurance protection, designate the ILIT as the owner from the outset.
The ILIT may be “funded” or “unfunded.” With a funded trust, you also transfer assets that may be used to pay the premiums. This could be cash, securities or some other property. However, if you use this method, the trust income is generally taxable to you. Conversely, with an unfunded trust, you don’t move over any other assets to cover the cost. Instead, you effectively pay the premiums out of your own pocket by making annual gifts to the ILIT.
Not only are proceeds from your life insurance policy removed from your taxable estate, the ILIT can be used for a variety of other purposes.
For instance, you can use an ILIT to keep assets out of the clutches of creditors or to protect against wild spending sprees of offspring. What’s more, the life insurance policy doesn’t have to pass through the probate process. Finally, life insurance may be used to cover any federal and/or state taxes without eroding other assets intended for the family.
The tax law allows a generous estate tax exemption of $5 million for each individual (inflation-indexed to $5.25 million in 2013). In other words, if you use an ILIT to remove life insurance proceeds from your estate, you have another $5.25 million to play with. ATRA sets the federal estate tax rate at a flat 40%. Thus, if you have a $1 million policy transferred to an ILIT, the estate tax savings may be as high as $400,000.
Also, because future earnings from life insurance policies will be taxed to the beneficiaries—not to you in your high tax bracket—the ILIT is being touted by some as a way to avoid the tax rate increase under ATRA (topping out at 39.6%) and the new 3.8% Medicare surtax on certain investment income taking effect in 2013.
Caution: An “irrevocable” trust means you can’t go back and undo the ILIT. Otherwise, the death benefit proceeds would be included in your taxable estate. And you could cause adverse results under federal and state laws if you name yourself as trustee.
Tip: Congress has threatened to eliminate or curtail the tax shelter for life insurance. That’s another reason to jump on the ILIT bandwagon before it’s too late (see box below).
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