Holding a life insurance policy can provide peace of mind if you have concerns about your loved ones’ financial well-being after your death. Whether you “hold” the policy or a trust holds the policy can result in different tax outcomes. In short, if you’re left holding the policy at death, its proceeds will be included in your taxable estate and may be subject to estate taxes. To avoid this result, consider creating an irrevocable life insurance trust (ILIT) to hold the policy.
Learn the basics
Life insurance proceeds will be included in your estate if you possess any “incidents of ownership.” This goes beyond mere ownership of the policy. If you have the right to amend the policy — say, by changing beneficiaries — or you can borrow against the cash value, it’s treated as an incident of ownership.
A common method for avoiding these estate tax complications is to use an ILIT. This may be accomplished by setting up the trust as the owner of the policy when the coverage is purchased or by transferring an existing policy to the trust.
For starters, the trust must be “irrevocable,” as the name states. In other words, you must relinquish any control over the ILIT, such as the right to revise beneficiaries or revoke the trust. You shouldn’t be the trustee of the ILIT that owns insurance on your life. Generally, such an arrangement will be treated as an incident of ownership. You can, however, name another family member or a knowledgeable professional as the trustee.
Typically, you’ll designate the ILIT as the primary beneficiary of the policy. Upon your death, the proceeds are deposited into the ILIT and held for distributions to the trust’s beneficiaries. In most cases, this will be your spouse, children, grandchildren or other family members.
Beware the pitfalls
There are a few pitfalls to watch out for when transferring an insurance policy to an ILIT. For example, if you transfer an existing policy to the ILIT and die within three years of the transfer, the proceeds will be included in your taxable estate. One way to avoid this is to have the ILIT purchase the policy on your life and then fund the trust with enough money over time to pay the premiums.
Note that the ILIT must be funded so the trust is able to pay the premiums on the policy. Choose a separate bank account to be used for this purpose.
Preserve your wealth
Life insurance is a powerful estate planning tool. It creates an instant source of wealth and liquidity to meet your family’s financial needs after you’re gone. To shield its proceeds from estate taxes, thus ensuring more money for your loved ones, consider transferring your policy to an ILIT. Your estate planning advisor can help with this process.