In our article 5 Roles of Life Insurance You May Not Have Considered, we addressed the role that life insurance can play in an estate plan. This article explores a common vehicle which both excludes the proceeds of the insurance from your taxable estate and also ensures the proceeds are used for their intended purpose.
A common misconception about life insurance is that it is “tax free.” Life insurance proceeds (specifically, income generated by whole-life policies) are income-tax free, but they are not estate-tax free. The proceeds of a policy—whether term or whole—will be calculated as part of your gross taxable estate for the purpose of calculating the applicable estate tax. If you own an insurance policy, or have the abilities of ownership (i.e., the right to change the beneficiaries on the policy), then the entire insurance proceeds would be taxable in your estate when you die.
As I mentioned last month, life insurance can provide several important benefits to your estate plan. Although the state and federal estate tax exemptions are much higher today than they were in years past, if you have a taxable estate, life insurance can provide your beneficiaries with available funds to pay future tax liabilities. Presently, New York State imposes a tax on estates valued at more than (approximately) $5.5 million, and the Federal government imposes a tax on estates valued at more than $11.2 million. However, there was a not-so-long-ago time that the New York State exemption was $1 million and the Federal Exemption was only $2 million. Thus, if your estate is comprised of illiquid assets—such as real estate, stock, or an interest in a business—life insurance can provide necessary available funds to your family so that they will not have to sell assets in order to pay taxes and other liabilities.
If estate taxes are a problem, you can create an insurance trust, which owns the life insurance policy. This will avoid estate taxes for insurance proceeds when you die. If you already own an insurance policy and you transfer that policy to an irrevocable trust, then estate tax liabilities will not be avoided for three years. The rule is that any assets transferred to the trust within the three years of your death will be recaptured and brought back into your estate for estate tax purposes.
This type of trust, called an Irrevocable Life Insurance Trust, is a form of irrevocable trust that can help exclude life insurance from your gross taxable estate, and thereby from estate taxes. An Irrevocable Life Insurance Trust owns, controls, and is the beneficiary of your life insurance policies. It cannot be changed or amended once created (although the grantor can always stop making gifts to the trust to pay the premiums). Existing policies are transferred to the trust, or the trust buys new policies on the grantor’s life.
For owners of small businesses, life insurance can be a crucial part of a solid estate plan. For many business owners, their net worth is inextricably intertwined with the business itself, and the business is an illiquid asset that cannot be readily sold. The Internal Revenue Service is not sympathetic. It demands that estate taxes be paid in cash within nine months of death, even if you file for an extension to file the taxes. Although there is a provision in the tax code for applying for an “installment plan,” it is not a request that is readily granted, and the IRS charges interest on the installments. Often the survivors of business owners who failed to plan are required to use the little cash or liquid investments that were left to them—and on which they expected to depend to satisfy daily needs—to pay the estate taxes and expenses of administrating the estate.
An Irrevocable Life Insurance Trust can be used as a vehicle to hold insurance policies so that the death proceeds are payable to the trust and pass to the trust beneficiaries free of estate tax. The trust beneficiaries can then use those proceeds for their living needs or to pay whatever share of estate tax is generated by the business. But, by using the trust, the gross amount of the life insurance proceeds will not be eroded by taxes themselves. For business-owners and non-business owners, the Irrevocable Life Insurance Trust has other benefits, such as protecting the liquid assets from a spouse’s remarriage, divorce of children or beneficiaries, and protection from creditors of the spouse or children and grandchildren.
Here’s how an Irrevocable Life Insurance Trust works:
1. You gift money to the trust. Usually, you transfer enough money to cover the annual premium. In order to avoid paying gift taxes on the gift (or decreasing your available tax exemption at death), the trust usually gives the beneficiaries an immediate right to withdraw the gift contribution (usually a short window like 30 days). This is known as a Crummey power for the court decision that sanctioned it as a permissible methodology for rendering the transfer qualified for the annual gift tax exclusion ($14,000 in 2014).
2. The trustee of the trust then purchases life insurance on your life. Depending upon how the trust is set up, the trust may purchase insurance on the joint lives of you and your spouse. When you die, the trust receives the insurance proceeds from the life insurance company.
The Irrevocable Life Insurance Trust has many other benefits depending on your objectives, such as ensuring preservation of principal against creditors, remarriage of your spouse or of children-beneficiaries, or from the beneficiaries themselves in the case of a spendthrift or where substance abuse is an issue. It can help ensure that capital will remain in the trust for future generations if desired. A forced sale of other assets under duress or in bad market conditions can also be avoided or the impact softened. In short, the Irrevocable Life Insurance Trust is an excellent vehicle for ensuring your financial legacy, regardless of your net worth or anticipation of estate taxes.