The Irrevocable Life Insurance Trust (ILIT): Avoiding Taxes on Life Insurance Proceeds
If you own a life insurance policy, you may not realize that all of the policy proceeds will be included in your estate for federal estate tax purposes at your time of death. This means that if you own a $3 million term life insurance policy, the $3 million of proceeds will be included in your estate.
If the total value of your other federal estate assets (business, cash, stocks, retirement account, real estate, etc.) already exceeds the $5.34 million threshold, the full $3 million will be subject to the federal estate tax, which begins at 40 percent.
Thus, your effort to provide for your loved ones by purchasing a life insurance policy can be significantly diluted as they would effectively receive about half of that sum with the rest consumed by death taxes.
There is a way to avoid (not evade) taxing these proceeds, however, via an estate-planning tool called the Irrevocable Life Insurance Trust (“ILIT”). By having a designated trustee of this very specific trust own the life insurance policy, you can ensure that its proceeds will be available tax-free to your family.
When you create the trust with your attorney, you can decide who will control the policy, who will benefit from the trust and how payments should be made to beneficiaries. For an existing policy, the ILIT must be established at least three years before your death to be valid, which is the IRS’s way of preventing eleventh-hour transfers to avoid estate taxes.
For a new policy, the trustee should own the policy from the outset, which then avoids this “three-year rule.” It’s important to understand that once the trust has been created, your control of the policy ends. This means you can no longer change the beneficiary or borrow against the policy.
