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A picture of a trust.

Did you know that if you died tomorrow the proceeds from your life insurance policies may be taxed at 40%?

If your assets are in excess of the federal exemption amount, the federal government imposes a tax on your estate. This tax is commonly referred to as the “Death Tax”. For many of our clients, life insurance proceeds are the reason their assets reach and exceed the federal estate tax threshold, and ultimately become subject to the tax.

Thankfully, this estate tax nightmare is avoidable. An Irrevocable Life Insurance Trust (ILIT) is the remedy for many of our clients in this situation. An ILIT is a type of irrevocable trust that holds or “owns” an insurance policy or policies. The person creating the ILIT (the grantor) should not serve as trustee of the trust. This is the defining aspect of an ILIT—the grantor releases all rights to amend, control, or manage the trust. If the grantor retained the power to withdraw cash value or alter the document in any way, then the IRS would consider the insurance policy to be the grantor’s asset and include it in the value of his or her estate. An ILIT is designed to be separate and distinct from the grantor’s assets; the goal is for the policy to be excluded from the value of the grantor’s estate in order to avoid the federal estate tax.

Typically, the main and sole asset of an ILIT is a new life insurance policy purchased by the trust. The cash value of the life insurance policy can grow free of income tax within the trust, which makes them an ideal investment throughout the life of the trust. The purchase of a new life insurance policy is preferred due to a three-year lookback rule for existing policies under Sec. 2035 of the Internal Revenue Code. Transferring an existing policy would be included in the estate if the transfer was less than three years from the date of the grantor’s death.

It is important to note that there are numerous benefits to creating an ILIT besides relief from the federal estate tax. First, an ILIT can protect insurance benefits from divorce, creditors, and legal action against your beneficiaries. Additionally, an ILIT avoids probate of your insurance policy. Probate can be expensive, time-consuming, and available to the public. The seamless transition of your assets from your trust to your beneficiaries makes all trusts, including ILITs, worth considering. Lastly, your ILIT can provide guidelines for how you want the insurance proceeds distributed to your beneficiaries. For example, if one of your beneficiaries has immature spending habits, you can provide that they receive their share of the proceeds slowly over time or at certain ages. This depends on what works best for each client’s unique situation.

Overall, an ILIT is a powerful tool that should be considered in wealth management and estate planning for those who may be approaching the estate tax threshold. An ILIT can provide you and your loved ones with significant benefits. The attorneys at Evans & Davis can assist you with determining if an ILIT is appropriate for you and your family.