A common misconception is that life insurance proceeds are entirely tax free. Well it is true that life insurance proceeds are generally free from income taxes, many people are both surprised and dismayed when they learn that their life insurance proceeds are subject to estate taxation.
To understand why life insurance proceeds are subject to an estate tax, we must first understand that the estate tax is a transfer tax. The Internal Revenue Service IRS taxes the transfer of wealth from one person to another dash transfers during life are subject to a gift tags and transfers during death are subject to nystate tags. When you die all of your property including life insurance proceeds would be taxed when it is transferred to your beneficiaries. In addition, the IRS will text the death benefits of any life insurance policy in which you have an incident of ownership. An incident of ownership includes any right to change the beneficiary from the policy or the right to borrow against its cash value.
Nonetheless, life insurance is extraordinarily helpful as state planning tool. It can provide critically needed funds to replace the income loss at the family’s breadwinner dies. It can also preserve an estate by providing the liquid iti needed to pay state taxes period without it, the family home, farm, or business might have to be sold to pay those taxes period
Despite these benefits, owning a life insurance policy poses one major estate planning challenge: although will offer your family needed financial security, it will also simultaneously increase the size of your taxable estate. In other words the death benefit of your life insurance policy might itself result in additional estate taxes that must be paid.
Can you explain more about taxes on life insurance?
As stated above, the IRS taxes all of the property that we transfer to others while we are still alive or at the time of our debts; However, there are few exceptions to this transfer tax period one such exemption is that under current tax laws every American citizen can transfer to others a certain amount of their property tax free. The amount of property that you can transfer tax free is known as the exclusion amount and is determined year to year by Congress. These taxes have been higher than 50% of the taxable estate value. The addition of life insurance proceeds can, and often do, pushes states over the exclusion amount. When this happens, otherwise tax free states become subject to state taxation simply because of these existence of life insurance. The result is that a large portion of the life insurance goes to pay state taxes instead of to the beneficiaries period since he exclusion amount is frequently changed by Congress, you should see a qualified estate planning attorney to learn the current amounts and to determine if your life insurance is rendering your state taxable.
Is there a way for me to protect my life insurance from estate taxes?
Although owning life insurance can add to the tax burden on your estate, there is a solution to this problem period the solution is to place your life insurance into a special trust known as in irrevocable life insurance trust ILIT
What is an ILIT?
And ILIT is similar to all trusts in that assets transferred to it are administered by a trustee who is required to follow the trust instructions. However, unlike revocable trust that are usually established for the trust makers benefit and which can be amended by the trust maker at anytime for any reason, and I’ll it is established for the benefit of someone other than the trust maker, usually the trust maker spouse or children. Furthermore, once created ilities usually cannot be amended, at least not without the permission of a court of law. Neither of these limitations, though, is usually significant in light of the great planning opportunities available with an IL it.
What planning opportunities do ILIT's provide?
An ILIT accomplishes two objectives. First, it removes life insurance death proceeds from your estate and thereby reduces the value of your estate for tax purposes. Second, it allows you to direct how the proceeds of your life insurance will pass to your beneficiaries.
A brief example shows how an IL it can provide can prevent your life insurance from triggering unnecessary state taxes period as stated earlier, if at the time of your death your property, including life insurance, exceeds the exclusion amount, your estate will have to pay taxes; However, if the life insurance is removed from your taxable estate by transferring it to nielle it, the taxable value of your estate will decrease by the amount of the life insurance removed from it. The smaller your taxable estate the smaller year estate tax burden.
The best thing about ILIT’s is that they are specifically designed to hold life insurance tax free. The life insurance death proceeds will pass to your chosen beneficiaries estate tax free because it was owned by the trust dash not by you. It is that simple.
Does this sound too good to be true? It is not if the IL it is properly drafted and implemented! In order to achieve this remarkable result, the islet must be drafted very carefully, the life insurance policies must be transferred to the ILIT in a specific manner, and the life insurance premiums must be paid in the correct fashion. Good advice from an experienced state of planning attorney is essential to making sure that each of these detailed steps, and others, are done correctly. You can also visit sites like academywestinsurance.com/services/ for additional guidance on insurance.
What other details are involved with creating an ILIT?
One important detail in creating an IL it is the selection of the trustee. Unlike revocable trust where you can be your own trustee, you cannot be the trustee of your own islet. The IRS will treat life insurance as if it is still in your taxable estate because you will have too much personal control over it. Your spouse or adult child may be the trustee, but because of the technical requirements of ilities, a better choice might be your accountant, another professional advisor, or a bank or Trust Company. The choice of your trustee should be given careful consideration.
Another important detail involving ILIT’s concerns for the transfer of the life insurance policy to the trust. You can transfer it either existing policies into your ILIT or you can have your trusty purchase a new life insurance policy that insures your life but is owned by the trust.
If you transfer an existing policy into an IL it, there are two cautions. The transfer of an existing policy to an IL it is treated under the tax code as a taxable gift, with the potential to trigger gift taxes. Whether or not the gift of an existing policy is taxable it depends on the value of the policy and the amount of the current gift tax exemption. The other drawback of transferring an existing policy to an ILET is that if you die within three years of the transfer, the IRS will consider the transfer invalid in the policy will still be included in your taxable estate.
These limitations make it preferable to purchase a new policy if you are still insurable. If a new policy is purchased, you will not have to be concerned with either determining an existing policy’s value for gift tax purposes or with the three year transfer rule. Many clients are not concerned about the small statistical chance of dying within three years of the transfer. They consider the opportunity to save sometimes hundreds of thousands of dollars of their life insurance well worth the risk and the cost of establishing the islet.
When a life insurance policy is transferred to an ILIT, the ILIT becomes responsible for paying the premiums necessary to keep it in force. The ILIT receives the funds needed to pay such premiums by accepting cash gifts from you or others. When these gifts are made, special care must be taken to ensure that no adverse federal gift taxes are encouraged. It would be pointless to avoid estate taxes only two incur gift taxes period careful planning is needed to simultaneously avoid gift and estate taxes.
Can I just give my life insurance policy to someone instead of creating an ILIT?
Questions frequently asked R, quote is it really necessary to go through all the steps needed to create and transfer life insurance to Anil it? Wouldn’t it simply be easier to remove the insurance from my taxable estate by gifting the policy to my spouse or another family member? End Quote although gifting a life insurance policy to someone else to remove it from your taxable estate as possible, there are a myriad of problems with someone else owning your policy. 1st when the policy is transferred to an individual, the same gift tax consequences must be considered that exists when transferring into an ILIT . The steps taken in creating an IL it make sure that the these gift tax issues are not overlooked.
Second, if his spouse or adult child owns a policy on your life, and he or she dies first, the policy’s value may cause an estate tax problem in his or her estate. Using an IL it can significantly reduce or even eliminate the estate tax spectre dash not merely shift the tax burden from one person to another.
3rd, when you transfer a life insurance policy to another person you lose all legal control over it. The new owner can change the beneficiary, take the cash value, or even cancel the insurance period creating an ILIT where your chosen trustee is required to follow your instructions concerning use of trust assets can prevent this. A trustee will be responsible for paying premiums and is more likely to keep the policy in force than what a child or children when called upon to write a check for the premium.
4th, when insurance is transferred to individuals, the beneficiaries usually receive the proceeds as an outright distribution after death. Your family would lose all of the distribution protections that exist when your life insurance is transferred to an islet. These in protections include the following:
- If your children are underage they cannot accept ownership of any death benefits period if a minor child is named as a beneficiary of a life insurance policy, the insurance company will not pay the proceeds to the child. It will instead force the matter into probate court where the court will probably order the proceeds held in a trust until the child’s 18th birthday. The child will then receive a cashier’s check for the remaining balance. This would not happen with an ILIT, which would allow you to maintain control over when and how children receive the proceeds;
- The death of a trust beneficiary would not result in the premature transfer of the policy to his or her spouse or minor child;
- Children may have asset protection from creditors, lawsuits, and divorcing spouses when life insurance is placed in an ILIT ;
- And ILIT guarantees the administrator of your state will have liquid iti needed to pay expenses and coordinate the administration of your state; ILIT’s permit the use of generation skipping transfers, a method used to pass unspent proceeds of the insurance from generation to generation without incurring taxes, that are not available with an outright distribution.
Creating an ILIT that meets your objectives and fits into your overall the state plant requires careful planning and the assistance of an insurance professional and estate planning attorney. If properly established and implemented, it is an excellent way to help create an estate, protect an estate from unnecessary taxation, and most importantly, provide a lasting legacy for your loved ones.