Many limitations have been placed on traditional tax shelters over time, but the benefits of “irrevocable life insurance trusts” (ILITs) remain intact. This is still a viable option to individuals who want to pass wealth to future generations without any adverse estate tax consequences.
Basic premise: Life insurance proceeds that are paid out from a policy where you are the insured are exempt from estate tax only if you don’t possess any “incidents of ownership” in the policy. Of course, this term applies if you own the policy outright, but it also encompasses more than many people think.
For instance you will be treated as having incidents of ownership in life insurance if you retain the legal right to do any of the following:
- Change or name the beneficiaries of the policy;
- Borrow against the policy or pledge any cash reserve it has;
- Surrender, convert, or cancel the policy, or;
- Choose a payment option for beneficiaries (e.g., you determine if payments will be made in a lump sum or installments).
Be aware that these rules apply if you have the right to take any of these actions whether or not you actually do so. If you have a policy with a six-figure death benefit, it could significantly increase the size of your taxable estate.
Fortunately, it’s relatively easy to avoid this result. All you have to do is establish an ILIT and transfer ownership of the policy, including all of the legal rights discussed above, to the trust. At the same time, you will also designate someone—perhaps a family member or an estate planning professional—to act as the trustee. If you want to acquire additional life insurance protection, you can designate the ILIT as the owner of any new policies you acquire.
The ILIT setup provides some other benefits that may appeal to wealthy individuals. With the appropriate legal language, you can protect the money from spendthrift children or grandchildren or spouses of your heirs. Furthermore, the proceeds may be used to cover estate tax liability without diluting other assets intended for the family.
Granted, estate tax liability may not be a great concern under current law. Briefly stated, your estate tax exemption can shelter from tax up to $10 million of assets (indexed to $12.92 million in 2023). However, the exemption is scheduled to revert to $5 million in 2026, plus inflation indexing. Also, the law can always change again. Don’t dismiss the importance an ILIT can play in your estate plan.
Caution: To qualify for the estate tax break, the ILIT must be “irrevocable.” So you can’t change your mind once you pull the trigger on the deal. Furthermore, if you’re the insured individual, you’re not permitted to act as the trustee. Otherwise, you might bring the life insurance proceeds back into your taxable estate.
Finally, the proceeds will still be subject to federal estate tax if you die within three years of transferring ownership to the trust. Because of this three-year rule, don’t delay if you think an ILIT is right for your situation. Start the clock running now.
Thanks for reading CPA Practice Advisor!
Subscribe Already registered? Log In
Need more information? Read the FAQs
Tags: Benefits, Income Tax, IRS, Taxes
