How to Ensure Your Life Insurance Proceeds are Actually Tax-Free

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Using an ILIT to Avoid Estate Tax
One way to avoid having the life insurance proceeds included in your gross estate is to structure the policy in such a way that you avoid the aforementioned “incidents of ownership.” This can be accomplished through the use of an Irrevocable Life Insurance Trust.

An Irrevocable Life Insurance Trust (ILIT) is pretty much what it sounds like. That is to say, an ILIT is a trust that (generally) cannot be modified or revoked once it is created.

In order to understand how and why setting up a life insurance policy this way works, a brief primer on life insurance is necessary. When it comes to life insurance, there are four main parties involved: the insurance company, the beneficiary of the policy, the insured (the person whose life is insured by the policy), and the owner of the policy.

The policy owner is the one who has the rights afforded to them by the insurance contract. The owner is the one who can, for example, name the beneficiary, surrender the policy, or transfer ownership. Notably, the owner and insured do not have to be the same person (though commonly are); this is what makes the ILIT possible.

The basic structure is simple. You set up an ILIT, then the ILIT purchases the insurance policy (as the policy owner). You are the named insured (ie: it’s a policy on your life), and the trust names a beneficiary (just as you would if you were the policy owner). Obviously, there are some additional considerations and nuisances, but that is the gist of it.

One of the key things to consider is who makes the premium payments. In order to preserve the integrity of the ILIT structure, the trust – not you – must pay the premiums. However, in most cases this hurdle is easily overcome by using the annual gift tax exclusion.

Under the tax code, each individual is allowed to gift an amount to any other individual tax-free. In 2016 that amount is $14,000. That means that you can make a monetary gift to the trust for the amount of the premium payments. (Assuming, of course, that you’re able to keep the annual premiums below the $14,000 limit.) The trust then uses that money to pay the insurance premiums, thus avoiding any incidents of ownership on your part.

The policy pays out to the beneficiary named (rather than to your estate). The value of those proceeds is then excluded from the gross estate value. Thus, they avoid being subject to gift tax, regardless of the size of your estate.

Additional Benefits to Using an ILIT
On top of the estate tax benefits, the use of an ILIT can present other advantages as well.

For instance, as with most other trusts, an ILIT can be more highly-customized. It can be structured so as to not to pay the beneficiary (or beneficiaries) immediately. This can be useful with a minor beneficiary, or one incapable of handling a sudden, large payment. This allows the trustee of the ILIT to act as a supervisor or manager of the funds in the trust. They can distribute the funds according to the wishes of the grantor (trust maker), and the terms of the trust.

Along those same lines, an ILIT can provide a certain level of asset protection to the beneficiaries. This is because the beneficiaries do not own the ILIT. Because of this, the assets of the ILIT are hard for creditors (and courts) to reach.

That being said, it is worth noting that using an Irrevocable Life Insurance Trust is a complicated and highly specialized technique. As such, it is always advisable to consult with your estate-planning attorney and/or financial advisor when considering making these sorts of significant changes to your estate plan.

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