Estate Planning with Life Insurance

Proceeds from life insurance policies often comprise a large portion of the average estate and many people recognize the importance of purchasing a life insurance policy in order to protect one’s family.  However, many people are not aware of the potential tax implications associated with a large insurance payout.  Insurance proceeds may be subject to estate tax, thereby significantly reducing the funds available to your loved ones.

The Rules

  • If, as of the date of death, your gross estate is valued over the exempt amount ($5.34 million for decedent's dying in 2014), then your estate will be subject to federal estate tax at a top rate of 40%.
  • Similarly, in New York State, if your estate is valued over $1 million, your estate will be subject to New York State estate tax at a top rate of 16%.  In New Jersey, if your estate is valued over $675,000, your estate will be subject to New Jersey estate tax (and possibly NJ inheritance tax).
  • According to Internal Revenue Code §2042, the proceeds of a life insurance policy are counted as part of the gross estate if the decedent “possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person.”  This is true whether the proceeds are payable to a named beneficiary or directly to the estate.
  • Incidents of ownership include, but are not limited to, the power to:
      • Change the beneficiary or contingent beneficiary
      • Borrow under the policy
      • Surrender or cancel the policy
      • Assign or revoke the assignment of the policy
      • Change the time and manner of receipt of the proceeds
      • Veto or consent to an action with respect to the policy

How to Protect Your Assets Through Estate Planning

An irrevocable life insurance trust (ILIT) is an estate planning technique where the insured gives up the “incidents of ownership” so that the proceeds from a life insurance policy no longer count as part of the insured’s gross estate.  As the name implies, once the trust is created you cannot revoke or cancel the trust. Typically, a person (whom we’ll call the “Trustor”) first creates an irrevocable life insurance trust, and then it is the trust that purchases the life insurance policy.  As the purchaser of the policy, the trust is the owner of the policy.   The trust must also be named as the beneficiary of the policy.  Because the trust owns the policy, the Trustor (you) have no control over the policy, or “incidents of ownership”. Even though creating an irrevocable trust means you cannot change the beneficiaries of the trust or of the insurance policy, you are entitled to name the beneficiaries of the trust when the Trustor creates it.  In other words, upon the death of the insured, the insurance proceeds will be paid to the trust since it was named as the beneficiary on the insurance policy.  Once the proceeds have been distributed to the trust, the trustee will then distribute the proceeds to the named beneficiaries of the trust as provided in the trust agreement.  The end result is that the life insurance proceeds will be paid directly to your named beneficiaries, as provided in the trust agreement, as though they were named as the beneficiaries of your life insurance policy (with certain restrictions).  The significant difference is that these proceeds will no longer be countable as part of your gross estate and thus not subject to federal or state estate tax.

Caveats

  • Transferring an existing life insurance policy: If you purchase a life insurance policy (instead of first creating an ILIT and having the trust purchase the policy) and then transfer the policy to the trust, the proceeds of the life insurance policy will be treated as part of your gross estate for three years following that transfer.  If death occurs more than three years after the transfer, the life insurance proceeds are not countable toward your gross estate.
  • The trust must pay the premiums of the life insurance policy.  You can fund the trust with up to $14,000.00 annually in order to pay the premium with no tax consequences under the gift giving exemption (provided certain procedures are followed).  Therefore, you are in essence still paying the insurance premiums.   However, it is important to keep in mind that gifting any amount in excess of the $14,000.00 annual gift exemption to the trust will result in federal tax consequences.
  • Remember, there is no single solution for all estates.  Everyone should have an individualized plan that meets the person's specific estate planning goals.

If you have a large life insurance policy, an irrevocable life insurance trust may be an integral part of your estate planning.  Due to the complexities involved in creating a trust, it is recommended that you consult with an estate attorney who is familiar with the creation of irrevocable life insurance trusts and the various tax implications and requirements. 

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