An irrevocable life insurance trust (ILIT) is a straightforward solution for a common estate-planning problem. Because life insurance is included in the taxable estate when a policyholder dies, it can be subject to estate tax. So if you have life insurance — and according to the Life Insurance Marketing and Research Association, more that half of all Americans do — you may want to consider establishing an ILIT.
In general, the proceeds of a life insurance policy won't be included in your taxable estate if you don't own the policy at the time of your death. However, life insurance proceeds will be included in your estate if you possess any "incidents of ownership." This phrase connotes more than mere policy ownership. You possess incidents of ownership if you have the right to amend a policy — say, by changing its beneficiaries — or you can borrow against its cash value.
In 2024, the top estate tax rate is 40%. But with your gift and estate tax exemption, you can shelter up to $13.61 million of the proceeds from federal gift and estate tax in 2024. However, note that without congressional action, this exemption is scheduled to revert to $5 million (indexed for inflation) after 2025.
You may also have to contend with estate or inheritance tax at the state level. In any event, the estate tax treatment of life insurance policies is a key consideration in estate planning, especially for wealthier individuals.
A common method for avoiding estate tax complications when you own life insurance is to use an ILIT. This may be accomplished by setting up the trust as the owner of your life insurance policy when coverage is purchased or by transferring an existing policy to your trust. The trust is "irrevocable" — meaning that you must relinquish any control over it. So, for example, if you act as the trustee of your ILIT, this will be treated as an incident of ownership and will invalidate the trust. However, you can name a family member or professional advisor as the trustee.
You'll designate the ILIT as the primary beneficiary of your life insurance policy. Then, on your death, the proceeds will be deposited into the ILIT and held for distribution to your trust's beneficiaries. In most cases, this will be your spouse (if you're married), children or other family members. But naming your surviving spouse as the sole beneficiary may become problematic because it can delay estate tax liability until your spouse dies (assuming he or she outlives you). Discuss this issue with your estate planning advisor.
There are other pitfalls to watch for when transferring an insurance policy to an ILIT. For one, if you die within three years of the policy 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. Another potential hazard: Transferring an existing policy to an ILIT is considered a taxable gift — as are subsequent transfers. Fortunately, such gifts can be sheltered from tax by your available gift and estate tax exemption.
Whether you own one or multiple life insurance policies, they can represent a tax liability. Going without insurance, however, usually isn't a realistic solution if you have family members who will require liquidity should you die. Contact your estate planner to discuss whether an ILIT can help make your plan more tax efficient.
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