Removing Life Insurance Proceeds From Your Taxable Estate

Many people aren’t aware that all of the proceeds from life insurance policies that they own at death will be included their estate for estate tax purposes. This is because if the policy owner can withdraw the cash value and change the beneficiary, then the policy owner will be deemed to have incidents of ownership over the proceeds and the IRS and, if applicable, state taxing authorities, can then tax the proceeds at death.

Thus, if you own a $6,000,000 term life insurance policy at the time of your death, then the insurance proceeds will already use up more than half of your $11,180,000 exemption from federal estate taxes. The result is even worse for residence of Washington State because Washington’s estate tax exemption is only $2,193,000.

How an Irrevocable Life Insurance Trust Works

One way to avoid the taxing of life insurance proceeds at death is to establish an Irrevocable Life Insurance Trust, or ILIT for short.

An ILIT is a type of irrevocable trust that is specifically designed to hold and own life insurance policies. Once the ILIT has been set up, you will transfer ownership of your life insurance policies to the Trustee of the ILIT. While you can’t be a Trustee of the ILIT – otherwise you’ll be deemed to have incidents of ownership in the life.

Once you’ve transferred ownership of the life insurance to the Trustee of the ILIT, you will have given up all of your incidents of ownership over the policies. Since you’ll no longer own the policies, the proceeds can’t be taxed in your estate when you die.

 

Who Are the Beneficiaries of an ILIT?

The ILIT will also be designated as the primary beneficiary of your life insurance policies. Thus, after you die, the insurance proceeds will be deposited into the ILIT and held in trust for the benefit of your children or other beneficiaries. Aside from this, the ILIT can provide your family with a quick source of cash to pay your estate tax bill while at the same time not increase your overall estate tax burden.

 

Other Benefits of using an ILIT

One of the main reasons people set up an ILIT is to help provide their heirs with flexibility in settling their estate. One difficulty heirs often face is a lack of cash to pay estate taxes. (The top federal estate tax rate for 2018 is 40%. Also, the State of Washington imposes separate state estate tax.) As a result, heirs may be forced to sell real estate, stocks, or a family business to raise cash.

Aside from being an administrative headache to accomplish in the 9 months before estate taxes are due, selling assets may not conform with your wishes or those of your family. For example, heirs may want to keep the home, jewelry, or other assets you have passed on but they may be forced to sell them to raise cash. Or the timing could be inopportune—a slumping stock market or depressed real estate values could force the estate to liquidate assets at low values. Another hazard of a forced sale is the potential to trigger income with respect to a decedent—in essence, forcing your heirs to pay additional taxes in order to settle the estate tax bill.

A key advantage of an ILIT as compared to personally owning the insurance policy is that if the trust is set up and administered correctly, the assets owned by the ILIT will not be considered part of your estate for federal inheritance/estate tax purposes—meaning your heirs won’t have to pay estate or inheritance taxes on the life insurance death benefits that are paid.

If you would like more information or would like to set up a time to discuss if an ILIT should be part of your estate planning, please call our office at 360-350-0272