When the proceeds from an estate are being distributed after death, many beneficiaries are surprised to find that they receive a substantial amount less than anticipated due to the federal estate tax or the state tax that must be paid on these proceeds. Specifically, life insurance proceeds tend to account for a significant portion of an estate’s worth and are thus included when calculating estate taxes.
When combining what will be taxed from an estate, the executor of the estate must include any of these when reporting on an estate’s proceeds: funds in bank accounts, value of investment accounts, any property including cars and personal assets, life insurance proceeds, retirement accounts or funds, and the value of any business owned.
One way for your beneficiaries to avoid being taxed on your life insurance proceeds is by making an irrevocable life insurance trust (ILIT). An irrevocable life insurance trust allows the owner of the policy to give up their ownership to a trust so that it is no longer included with the other funds taxed upon death. While the owner of the policy cannot serve as a trustee due to their own benefit in the ILIT, it is common to name a spouse, relative, friend, or attorney to serve as the trustee. A trust is formed with the main purpose of the life insurance policy being distributed into the trust, which is not subject to the same tax as estates, thus leaving your loved ones with more.
While ILITs serve as a great tool in estate planning, there are some potential setbacks some can experience with the creation and distribution. For the policyholder, they give up their right to make decisions about the policy, which is purchased by the trust, namely they no longer have control over borrowing under or cancelling the policy, revoking the assignment of the policy, changing beneficiaries or consenting to an action regarding the policy. The policyholder however does still get to name the beneficiaries of the ILIT when it is created.
Additionally, if you did not initially create an ILIT when you purchased your life insurance policy, the IRS will still tax that policy if the policy owner dies within three years of making the transfer to the ILIT. Once the three years passes however, the life insurance policy will no longer be included for estate tax purposes and will be treated as a trust. In order for the trust to be valid, it must pay for the life insurance policy premiums out of the trust account. While this may subject the beneficiaries to gift taxes, this can also be avoided. Overall, the potential downfalls can be greatly outweighed by the benefits if planned for adequately.