by Jeffrey W. Jones, Esq.
Did you know that death benefits paid to your chosen beneficiaries from your life insurance policies may be included in your taxable estate? Most people are surprised to find out about this. Life insurance death benefits are not subject to state or federal income tax (in most cases), but they are subject to state and federal estate tax, unless the insured did not have any “incidents of ownership” in the policy.
Incidents of ownership are the legal rights of the owner of the policy. They include such important rights such as naming and changing beneficiaries, canceling, selling or exchanging the policy, and borrowing or withdrawing the cash value of the policy. In order to avoid taxation of the death benefit, the policy owner must transfer ownership of the policy to a third party.
Although policy ownership can be transferred to an individual (your spouse, or child, for example) or some kind of a legal entity such as a corporation, partnership of LLC, there can be adverse tax consequences and non-tax practical reasons that make such transfers less than ideal ways to avoid the estate tax problem. Enter the Irrevocable Life Insurance Trust, or “ILIT”.
The ILIT is an irrevocable trust with an independent trustee (not a member of your immediate family or anyone considered subordinate to you under tax law) and is considered a separate legal entity. It has its own federal tax identification number and must file annual state and federal income tax returns, although it usually has no taxable income while you are alive. When you die, the entity which owns the policy and collects the death benefit “lives on,” so to speak, so the death benefits are not taxed. The ILIT should have provisions for distribution of the death benefits (or holding them in a continued trust) which are coordinated with all other aspects of your estate plan. A single ILIT can own more than one life insurance policy.
If you transfer an existing policy to an ILIT, there is a three-year waiting period before the death benefits will be excluded from your estate. If you purchase a new policy, set up the ILIT first, have the Trustee sign the policy application and make sure the trust is designated as the original owner when the policy is issued. Even if you die within three years of issue, the death benefits should be excluded from your estate.
In addition to the annual tax returns, your trustee will have to set up a bank account, into which you will make periodic deposits sufficient to cover the annual premiums for the insurance. These deposits to pay premiums will be considered taxable gifts to the beneficiaries of the trust (your spouse and children, for example). However, in a properly drafter ILIT, if certain “notice” procedures are strictly followed, deposits and premium payments up to $14,000 per year, per beneficiary, can be disregarded under the annual gift tax exclusion. For example, if your two children and four grandchildren were the beneficiaries of the ILIT, up to $84,000 of annual premium could be paid without gift tax consequences. (If the premiums added up to the full $84,000, you could make no other significant gifts to the children and grandchildren; all gifts each year are counted toward the $14,000 per person limit.)
Because of the setup costs and careful attention that must be paid to it every year, an ILIT is not appropriate for every person and every life insurance policy. In the right circumstances, however, it can be a simple way to prevent 8% to 48% of the death benefit from falling into the hands of the tax collector. That’s money in the bank for your loved ones.
The information presented on this website is general in nature and not intended to be legal advice. No attorney-client relationship will exist with Jones, Kuriloff & Sargent, LLC unless we agree in writing after a personal consultation. Please contact us for a consultation on your particular situation.