Introduction. People are often surprised to find out that their life insurance proceeds will be part of their taxable estate at death -- even if the proceeds are payable to others, such as a spouse, children or other loved ones.
What about the Estate Tax Exemption? Every person has an exemption from Federal estate tax, so it’s only if the total estate (including the life insurance proceeds) exceeds the exemption that Federal estate tax is a concern. Currently that exemption is the largest it has ever been, at $5,340,000 (or over $10 million for a married couple combined). But that doesn’t necessarily solve all tax problems. First of all, there is a risk that Congress will shrink the exemption in the future (it was $1 million only a few years ago). Second, affluent professionals with young families may carry large amounts of insurance – and the insurance together with their other assets may put them over the taxable threshold. In addition, there are cases where substantial insurance is purchased either to provide directly for children or other relatives at death or for other reasons (for example, to furnish liquidity to pay estate tax at death), and the estate planning benefit depends on the insurance not being part of the taxable estate. Finally, some states (including NY) still impose an estate tax at $1 million, which must be addressed in the planning process as well.
What about the Marital Deduction? A person can leave property to his or her spouse free of estate tax under the so-called “marital deduction” (subject to special rules if the spouse is not a U.S. citizen). However, the marital deduction merely postpones the estate tax until the death of the surviving spouse, it does not eliminate the tax. Moreover, obviously, not all persons who purchase life insurance are married.
Is there a way to get life insurance proceeds out of the taxable estate? Yes, the solution is to transfer the insurance policy during lifetime (and at least 3 years prior to death) to an irrevocable life insurance trust, also known as an “ILIT.”
What is an ILIT? As the name implies an ILIT is an irrevocable trust designed to hold a life insurance policy. The person who creates the trust is called the “grantor,” there is a trustee who is in charge of managing the trust property, and the trust is for the benefit of family members (spouse, children, etc.) and/or other loved ones, who are called the beneficiaries. Irrevocable means the grantor cannot change the trust after it is created –this is necessary to keep the insurance proceeds out of the taxable estate.
Who can be the Trustee of an ILIT? Generally, anyone other than the grantor can be the trustee of the ILIT. For example, if the ILIT holds an insurance policy on the life of a husband, generally his wife can be the Trustee. It is usually good to also have an independent trustee (who could be close friend or even a family member, such as a parent, who is not a beneficiary of the trust) or at least a mechanism to appoint one. The trustee should agree not to receive any compensation for acing as trustee of the ILIT, at least during the grantor’s lifetime, because the ILIT will probably not be worth much until after the grantor dies when the insurance proceeds are received.
What happens to the property in the ILIT? Usually the ILIT says that as long as the grantor is alive, the trust property will be held in a trust for all of the beneficiaries. For example, a typical ILIT for a married person might say that during the grantor’s lifetime, the trust is for the grantor’s spouse and all descendants of the grantor. After the grantor dies, many different things could happen to the property – it could continue to be held in trust for all the beneficiaries, it could be divided into separate trusts for different beneficiaries, or it could be paid out to the beneficiaries. That is something the grantor would decide in consultation with his or her estate planning attorney at the time the ILIT is created. Remember that the ILIT usually will not be worth much until the insurance proceeds are received after the grantor’s death.
How does the grantor transfer the insurance to the ILIT? The grantor transfers the insurance to the ILIT by filling out a change of ownership form and delivering it to the insurance company. As the new owner the trustee of the ILIT must then fill out the appropriate insurance company form naming the ILIT as the beneficiary of the life insurance. Sometimes both those steps can be taken on a single form.
What if you are thinking about getting insurance but haven’t yet applied? In that case it’s better to set up the ILIT first, and then let the ILIT apply for, purchase and own the insurance from the start. That way, you are not subject to the 3 year waiting period.
Who pays the premiums on the insurance after the insurance is transferred to the ILIT? Usually the grantor continues to pay the premiums after the transfer to the ILIT. Those payments are considered gifts to the ILIT, but they can be set up to fall under the $14,000 annual exclusion in most cases. There are some special provisions (called “crummy withdrawal powers”) that have to be in the ILIT, and there is some minor annual paperwork that is required in order to qualify for the annual exclusion. This is the most common plan for premium payments and works well in most cases. If it is not suitable, an estate planning attorney can recommend an alternative structure.
Disclaimer – Postings Not Legal Advice
This blog is not legal advice and no attorney-client relationship is formed. The information and materials on this blog are provided for general informational purposes only and are not intended to be legal advice. The law changes frequently and varies from jurisdiction to jurisdiction. Being general in nature the information and materials provided may not apply to any specific circumstances. Nothing on this blog is intended to substitute for the advice of an attorney. If you require legal advice, please consult with an attorney licensed to practice in your jurisdiction.
