by: Shaina Case
Even with the federal estate tax exemption limit currently set at $11.4 million per individual (sunsetting in 2025 and reverting to $5 million per individual unless Congress changes the law before then), many are not aware that their taxable estate may include life insurance death benefit proceeds, which are often high amounts. Should the life insurance policy have a death benefit that would, cumulatively with their gross taxable estate, put their estate over the federal estate tax limit, there could very well exist a lofty federal estate tax. Fortunately, however, estate planning attorneys can draft around this potential issue through designing an irrevocable life insurance trust (“ILIT”). Here is how the ILIT, another type of estate planning trust, generally works:
The ILIT trustee owns the life insurance policy, thereby removing the value of the policy from your taxable estate. For example, if you had a life insurance policy valued at $5 million and your other property is valued at $7 million at the time of your death, your gross estate would exceed the $11.4 million federal estate tax exemption limit. This means your estate (and your family as your estate’s likely named beneficiaries) could owe estate taxes on $600,000 of your estate—the amount over the federal exemption). Making the ILIT trustee the owner of the life insurance policy avoids this scenario by removing the $5 million life insurance policy from your taxable estate.
Existing policies can be transferred into the ILIT after formation or the ILIT trustee can purchase the policy directly. To avoid the life insurance policy from being included in your estate for estate tax purposes, however, not only does the ILIT trustee (not you) own the policy but you also cannot serve as the ILIT’s trustee and the ILIT must be irrevocable. That is, you cannot have any “incidents of ownership,” meaning upon creating the trust, you must remove your involvement and control over the policy and the ILIT. Instead, you appoint a friend, adult child, corporate trustee, etc. to serve as trustee.
The ILIT is generally the named beneficiary of the life insurance policy so that, at death, proceeds are paid into the ILIT and then held in trust for the benefit of the ILIT beneficiaries. This is another benefit to using the ILIT because, if, for example, the primary beneficiary of the ILIT is a spouse, the spouse could receive regular incremental payments, rather than a lump sum. A benefit of receiving incremental payments, rather than a lump sum, is that the spouse may avoid an estate tax as part of the spouse’s eventual estate and could also provide creditor protection.
Other considerations also must be taken into consideration in establishing an ILIT (i.e., avoiding gift taxes by employing the “Crummey” withdrawal rights).
Life insurance policies can be an incredibly useful and powerful tool to protect our loved ones at our death. ILITs may not be a key tool for all estate plans; however, they are similarly an incredibly useful and powerful estate planning tool to continue ensuring that your family, and your estate, are protected from estate taxes at the time of your death.