“There is a common misconception that life insurance benefits are not subject to estate tax. While the proceeds of a life insurance policy are not taxable income to the beneficiaries, they are part of a person’s taxable estate, if the insured dies owning the policy.”
The threshold for each state’s estate tax needs to be considered, when the family is doing estate tax planning. This is because many are not as high as the current federal estate tax exemption. As part of an overall estate planning strategy, says JD Supra in the article “Estate Planning: The Irrevocable Life Insurance Trust,” an Irrevocable Life Insurance Trust, or ILIT, can be used to take the life insurance proceeds out of a donor’s taxable estate. One catch: the donor (the owner of the policy) must live for three years after the policy is transferred to the trust, in order for the proceeds to be excluded from the estate for any estate taxes.
The donor should also not be the trustee and may not retain any economic benefits from the policy, including the ability to change beneficiaries, to cancel or surrender the policy or to assign the policy.
If the donor is married, the surviving spouse may be a trustee, but should not be the sole trustee for most situations. A family member, or even a professional trustee, may serve as a co-trustee with the spouse.
The terms of the ILIT provide for the funds to be distributed to beneficiaries, or they also may be linked to another trust. That might be a Special Needs Trust or a Revocable Trust.
An ILIT also offers a level of asset protection to beneficiaries from creditors.
The ILIT pays policy premiums through gifts made to the trust. These gifts, it should be noted, do not qualify for the current $15,000 annual gift tax exclusion, unless the beneficiaries of the trust are given some very specific powers that will allow them to withdraw the gift to the trust for a period of time. These powers are known as “Crummey” powers (named for the first person to use the structure). The trustee in this case must send “Crummey” notices to all the beneficiaries telling them about their withdrawal rights when there is a contribution to the trust. An estate planning attorney will be needed to create and manage this.
An ILIT can be funded with term or permanent insurance that is in effect for the owner’s lifetime. To pass the proceeds outside of the donor’s estate, the donor may not borrow against or access the cash value of the insurance policy, once the life insurance policy has been transferred into the ILIT. However, the donor could indirectly benefit from the cash value through his or her spouse, who is a beneficiary of the ILIT.
Another way to use an ILIT is to establish it by a married couple and fund it with a second-to-die life insurance policy. The second-to-die policy pays out to the surviving spouse’s death and is often used as cash to pay estate taxes on illiquid assets or to fund a special needs trust.
Reference: JD Supra (Jan. 21, 2019) “Estate Planning: The Irrevocable Life Insurance Trust”