You have a life insurance policy, and you want to make sure that no one has to pay taxes on the policy proceeds after you pass away. One big concern is estate tax: since the life insurance policy will have a large payout, your estate’s total value could take a huge hit if it must pay estate tax on the payout. If you transfer the life insurance to an ILIT, you may be able to reduce potential tax liability.
Is Life Insurance Part of Your Taxable Estate?
Life insurance proceeds may be part of your taxable estate if (1) your estate is a beneficiary of the policy, directly or indirectly, or (2) you have “incidents of ownership” in the policy. Incidents of ownership include the legal right to borrow against the life insurance policy, surrender or cancel the policy, change the beneficiaries, or select beneficiary payment options. In addition, paying the premiums yourself may be an incident of ownership. If you would like to eliminate the possibility that the life insurance will be included in your taxable estate, you can transfer the policy to an ILIT.
The Three-Year Rule
An ILIT is an Irrevocable Life Insurance Trust. Usually, you make the ILIT the beneficiary of your life insurance policy. The ILIT holds any money paid from the policy in trust for the beneficiaries you name in the ILIT trust document.
If you transfer ownership of your life insurance policy to an ILIT, the IRS could still consider the policy to be part of your taxable estate. Gifts of life insurance policies made in the three years before an owner dies are subject to federal estate tax. This is known as the Three-Year Rule.
Despite the Three-Year Rule, transferring your policy to an ILIT could help with estate tax liability in the future. Note that you cannot continue to pay the premiums yourself after you make the transfer, or the IRS will find that you still have an incident of ownership. Instead, you can transfer money to the ILIT, and then the trustee can make the premium payments with that money.
Further, you cannot be the trustee of your own ILIT, and the trust must be irrevocable. You have to give up any rights to make changes to the trust. If you do not, the IRS may find that you still have incidents of ownership and include the policy proceeds in your taxable estate.
Planning your estate? Look to Janet Brewer, Esq. for thorough and thoughtful estate planning advice. Janet’s more than 20 years of legal experience will give you confidence and peace of mind. To schedule a “Get Acquainted” meeting, visit Janet's website or call her office at (650) 469-8206.