Along with a carefully constructed estate plan, a life insurance policy can be a great way to provide for your family and beneficiaries after you pass away. And one of the biggest advantages of a life insurance policy is the tax benefits it can offer.
Generally, the death benefits of a life insurance policy are not subject to income taxes. But just because death benefits are often exempt from income taxes does not necessarily mean that the beneficiary will avoid a tax bill entirely. If you own the policy at the time of passing, the death benefits will be included as part of your estate. This means that those benefits may be subject to estate taxes.
However, there is a way for you to distribute death benefits from your life insurance policy without incurring an estate tax liability: establish an irrevocable life insurance trust (ILIT).
What Is an Irrevocable Life Insurance Trust?
An ILIT is a type of irrevocable trust that’s specifically designed to hold and own life insurance policies. Here’s how it works: You establish the trust and contribute your life insurance policy as a trust asset. At the time of your passing, the death benefits of the policy are transferred to the trustee, and the trustee then distributes those benefits according to the terms of the trust.
Rather than owning the policy yourself, you instead name the trust as the owner. By making the trust the owner of your policy and naming the trust—not your estate or heirs—as the beneficiary, the policy is effectively removed from your estate, so beneficiaries of the trust won’t be forced to pay estate taxes on the payout.
What Are the Benefits of an Irrevocable Life Insurance Trust?
Without question, the greatest benefit of establishing an ILIT is the potential to reduce or outright avoid your estate tax liability.
Although insurance proceeds that your beneficiaries receive at the time of your death aren’t generally subject to federal income tax, proceeds payable to your estate or heirs are included in the value of your total property owned at the time of your death. This total property is known as your "gross estate," and anything within your gross estate may be subject to federal and state estate tax.
Establishing an ILIT can allow you to better position the wealth you pass on to your family and heirs and reduce or even eliminate the amount owed in federal and/or state estate taxes. In 2021, the federal estate tax exemption is fairly high at $11.7 million. This means that a gross estate valued at anything less than $11.7 million is not subject to federal estate taxes.
However, many states have their own estate tax exemption, and that threshold is typically lower than the federal exemption (for example, Massachusetts and Oregon have the lowest estate tax exemptions at only $1 million). This means that although you may be exempt from federal estate taxes, your estate could still be subject to state estate taxes when you pass.
An ILIT can help relieve this tax burden in a couple ways: First, by placing your life insurance policy in a trust, it’s removed from your gross estate, so the payout of your policy isn't counted when adding up the value of your estate.
For example, let’s say you live in Minnesota, where the state estate tax exemption is $3 million. Your total estate (home, vehicles, jewelry, bank accounts, etc.) is valued at $2.5 million, and you have a life insurance policy that’s set to pay out $600,000. In this case, your gross estate would be $3.1 million, meaning you would be exempt from federal estate taxes, but you’d have to pay estate taxes to the state of Minnesota. If you had instead placed your life insurance policy inside an ILIT, that $600,000 payout would be removed from your gross estate, bringing the value down to $2.5 million and eliminating your estate tax burden altogether. And even if an ILIT can’t help you avoid estate taxes, it can at least bring down the value of your estate, thus reducing the amount you’d owe in taxes.
Second, by placing your policy inside an ILIT, you create an immediate source of liquid cash that can be used to pay for expenses. If your estate is large enough that you have to pay estate taxes no matter what, it can be a smart move to have the death benefits from your life insurance policy transfer to the executor of your estate. That payout can then be used to help pay for various estate taxes and other settlement costs, which might also effectively bypass estate taxation. This method can be an affordable way to pay for any expenses that occur with the execution of your estate.
Is an Irrevocable Life Insurance Trust Right for Me?
Before considering an ILIT for your estate plan, it’s important that you keep a few things in mind. Like any insurance policy, you still need to pay premiums to keep the policy active. When establishing the trust, you can add additional assets to help pay the premiums (this is called a “funded ILIT”), but this might also incur a gift tax liability, and any gift made to an irrevocable trust cannot be taken back. Otherwise, every year you must make additional deposits into the trust to cover the cost of the life insurance premiums (called an “unfunded ILIT”).
Additionally, since an ILIT is an irrevocable trust, you will also lose day-to-day control over how the assets within the trust are used. The trustee will maintain the trust and administer the death benefits to your beneficiaries after you pass, but only in accordance with the terms of the trust, and the terms are laid out at the time the trust is established.
Setting up an ILIT has many benefits, but it’s also a complicated procedure. Because of the amount of expertise required, it’s recommended that you work with your financial advisor or an experienced estate planning attorney. Planning ahead can help you fully utilize all the tax advantages a life insurance policy can offer you and your loved ones.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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CFP ®, ChFC ®, AIF ®, Series 7 & 24 Securities Registrations,* Series 66 Advisory Registration,† Insurance License Having worked in the industry since 2007, Adria regularly meets with clients and works closely with the Roundtable™ team of specialists to develop financial plans that are specifically geared toward their values and retirement goals. She is involved in her Arlington Heights, IL community through Our Lady of the...Read More