Life insurance is an easy way to provide liquidity to loved ones when you die. Many of us purchase life insurance as part of providing for our family. A misnomer is people believe life insurance is not part of their taxable estate. You do not pay income tax on life insurance proceeds. However, the proceeds are absolutely includable in your “gross estate” of the policy owner for estate tax purposes at the policy owner’s death and are potentially subject to federal tax. Your family absolutely pays estate tax on life insurance. Unfortunately, at the current 45% federal estate tax rate, almost half of the life insurance proceeds would be payable to the Internal Revenue Service for federal estate tax rather than passing to the policies beneficiaries. Therefore, if you have a large amount of life insurance or you planning on purchasing a large amount of life insurance you might want to consider putting it outside of your estate.
An Irrevocable Life Insurance Trust owns your life insurance policies. The terms of the trust govern what happens to the money after you die. The proceeds can be used to pay for estate tax. If it is not needed to pay for estate tax the proceeds can be used to take care of your loved one. Since the money is outside of your estate it is an easy way to leave money to your children outside of your estate to grow outside of your estate.
For example, there is an ILIT with a $1 million life insurance policy on the life of the person creating the ILIT and the trustee of the ILIT is the oldest child who is also a beneficiary of the ILIT. There are two other children who are beneficiaries. The trustee would then manage and dispose of the life insurance proceeds pursuant to the terms of the trust agreement which is to first pay estate taxes and then distribute any leftover money equally to the three children. The result is that the $1 million of life insurance proceeds is ultimately transferred to the children of the insured free of federal estate tax.
Additionally, the provisions of the ILIT can provide liquidity for the estate of the insured. For example, the estate of the insured may consist of hard-to-sell assets, such as real estate, an interest in a business venture, closely-held stock or valuable artwork, and there is no ready cash or marketable securities to pay the federal estate tax within nine months after the death of the insured, which is the deadline for paying federal estate tax. Therefore, the terms of the ILIT can provide that the trustee be allowed to purchase assets from the estate of the insured at the fair market value for those assets. For example, if the estate of the insured owned a parcel of commercial real estate valued at $800,000 for which a buyer could not be found before the nine-month deadline, then the trustee could use $800,000 from the life insurance proceeds and purchase the parcel of commercial real estate. The estate of the insured now has $800,000 to use towards the payment of federal estate tax and other administrative expenses. The ILIT now owns the commercial real estate which produces ample monthly rental income to be paid to the surviving spouse and the future appreciation of the commercial real estate will ultimately pass to the children of the insured, without estate taxes having to be paid.
If you set up an Irrevocable Life Insurance Trust you cannot be the trustee of that trust and you cannot control the trust. By giving up the right to be the trustee and the control the IRS allows you to move the money outside of your estate.
If you want to set up an Irrevocable Life Insurance Trust with life insurance you already own you must live for three years after setting up the trust or the insurance will be included in your taxable estate.