Many people aren't aware that for tax purposes, their estates could include the earnings from their life insurance policies after they die. This could result in an increase in the estate tax obligation, depending on how much the policy is worth. But it's avoidable. It isn't an ironclad rule, and there are methods around it. To take ownership of the policy, one choice is to establish what is known as an irrevocable life insurance trust, which is also abbreviated as "ILIT."
What does an ILIT stand for?
A life insurance holding trust, often known as an ILIT, is a specific kind of living trust that was designed to hold life insurance policies. After the ILIT has been established, you have the option of either transferring ownership of an existing policy to the trust or having the trust purchase the policy on its own. Despite this, you are not eligible to serve as trustee of the trust. The trust must be irreversible, which means that you must "finance" it, placing the policy into its ownership, then move aside. You are required to give up any right you may have had to modify the trust or terminate it in any way. By taking on the role of trustee, you would be granted what is known as "incidents of ownership," which would enable you to maintain control over the insurance. However, you can appoint your partner, your grown children, a close friend, or even a financial institution or an attorney to act in the capacity of trustee on your behalf. When you are establishing trust, you are free to include anyone you wish.What Are Incidents of Ownership?
If you personally owned the insurance policy and continued to exercise control over it, you would have the ability to access the cash value at any time during your lifetime and make adjustments to the beneficiaries of the policy. That would make it your asset, and as a result, the Internal Revenue Service and maybe some state tax authorities would factor the proceeds of the insurance into the value of your estate. If the proceeds are large enough and sufficiently substantial, this may put your estate in a position where it is subject to estate taxes. Even if you name your son, daughter, spouse, or someone else as the beneficiary of the policy, the policy will still be considered an asset of your estate if you own it at the time of your death and the beneficiary of the policy is your estate. This is the case if your estate is the beneficiary of the policy.Estate Taxes
As of 2021, the threshold for the estate tax is rather high, standing at $11.70 million per estate. Estates only have to pay taxes on the portion of their values that is above that threshold. If you had life insurance for $5 million and the total value of your other assets was more than $6.7 million when you passed away, then you would be considered to have exceeded the exemption for this tax. Your estate, and by extension, your heirs, would be responsible for paying the estate tax on any value that exceeded the threshold of $11.70 million. Although only estates of a very high value are subject to federal estate taxes, several states do impose estate taxes with considerably lower thresholds than the federal government does. If the exemption in your state is one million dollars, the remaining balance of the death benefits on your policy, in addition to the amount of your estate, might easily put it into the taxable zone.Who Exactly Benefits from an Individual Retirement Income Trust?
The Individual Retirement Income Trust (ILIT) is typically named as the primary beneficiary of the insurance policy. When you pass away, any death benefits you have will be transferred into an ILIT, where they will be kept in trust for the benefit of the people you have designated in your trust deeds as being eligible to receive the money. Instead of receiving the proceeds in one lump sum, your spouse will get payment in installments on a monthly basis if the proceeds are placed in trust for her benefit. Assuming that the funds weren't drained by the time of her own death, they wouldn't be subject to the same level of taxation as they would be if the lump sum were to go straight to her rather than being included as part of her ultimate estate.Potential Complications
If you pass away during the first three years after transferring your life insurance policy to your ILIT, the Internal Revenue Service will nevertheless count the proceeds of the policy as part of your estate for the purposes of calculating estate tax. You can prevent this from happening by having the trust buy the policy on your life instead of you and then providing the trust with enough money over the years to cover the cost of the premiums. Because you are essentially giving the trust the money to pay for the policy each year, gift taxes are another factor that may need to be considered; however, this problem can also be circumvented. Every time you add new funds to the trust, the trustee of the trust can easily write a letter to the beneficiaries of the trust that is known as a "Crummey letter." Within a predetermined window of time, this letter would inform them that they have the right to request their portion of the money in question. A person is exempt from paying gift tax so long as they can demonstrate that they have an immediate claim to the money. When compared to the eventual proceeds of your insurance, the amount that you are contributing to the trust will undoubtedly be insignificant, particularly if it is going to be split among a number of beneficiaries. If they take the money now, the premiums won't be paid, and the policy will be canceled because it won't be renewed. In most cases, this serves as a sufficient incentive for the beneficiaries to leave the money with the trust so that it can be used to pay for the insurance.Putting an End to the Trust
After it has been established, an irrevocable trust typically cannot be revoked or altered in any way. To terminate the trust, however, you need to do nothing more than stop making payments for the premiums. This is due to the fact that the life insurance policy can only remain active if continued premiums are paid on a regular basis. After the policy expires, the trust would then be nothing more than an empty vessel.