Although not subject to federal income tax, life insurance death benefits can be subject to federal estate tax. Life insurance policies not only boost the value of your total estate, but the death benefit can also create an unexpected federal estate tax consequence. This, coupled with the uncertainty in the future of the federal estate tax, calls for careful planning. An irrevocable life insurance trust can be a very useful estate planning tool for this purpose.
Tax savings. The purpose of an irrevocable life insurance trust (“ILIT”) is to remove your insurance policy from your estate, thereby reducing or eliminating federal estate tax on the death benefit if you survive three years after transferring the policy. In addition, cash contributions made to the ILIT to cover insurance premium payments can qualify for the annual gift exclusion ($14,000 in 2016).
Greater flexibility. A skillfully crafted ILIT not only removes the death benefit proceeds from your estate for estate tax purposes, but also enhances your ability to direct how the insurance proceeds will provide for your loved ones. Once the ILIT instrument is drafted, your new or existing life insurance policy or policies are transferred to the trust. Cash can also be transferred to the trust to cover future premium payments. The trust owns the policy and is also designated as the beneficiary of the policy insuring your life. The trustee (someone other than yourself) makes sure that the insurance premiums are paid, properly manages the trust, and follows the directions you built into the trust regarding distribution of the insurance proceeds after your death.
Your ILIT provisions can be customized to distribute the insurance proceeds in a way that an insurance policy contract alone cannot. Whereas an insurance contract form generally only allows for a beneficiary designation, ILIT provisions can be specifically tailored. For example, an ILIT can direct that your spouse have the benefit of the income and the principal for his or her support during his or her lifetime, after which any remaining assets would be distributed to your children, either in trust or outright once the children reach a certain age designated by you.
Some ILIT caveats. Irrevocable life insurance trusts are, by definition, irrevocable: the trust cannot be changed once it is signed. Moreover, you must give up all ownership rights in the policy, including the right to modify the trust, change the insurance policy beneficiary designation, or borrow against the policy. In addition, someone other than you must serve as trustee in order to satisfy the irrevocability requirement. This irrevocability is necessary, however, in order to remove the insurance policy from your estate for estate tax purposes.
Annual Premiums. The annual insurance premiums, which are paid by you, qualify for the annual gift tax exclusion as long as the guidelines for gifting are met. Thus, if the premiums are less than the annual exlusion per beneficiary of the trust, the gift will be tax-free and will not count against your lifetime estate tax exemption ($5,450,000 in 2016). For example, if you and your spouse have four children who are beneficiaries of the ILIT, you can effectively move $112,000 ($14,000 x 4 kids x 2 spouses) out of your estate tax-free in 2016 and not have dipped into your lifetime exlusion.
If you would like to discuss how an ILIT might enhance your estate plan, please contact your L&B professional for more information.