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Using ILIT to Mitigate Tax Exposure on Life Insurance Earnings

Nov 16, 2022

A life insurance policy is a powerful technique for cash flow and estate planning. When you pass away, it creates an immediate stream of cash and liquidity to provide for your family's needs. While life insurance policies might offer comfort, the proceeds from the policy will be included in your taxable estate and therefore may be subject to estate tax. Instead, if you want to protect life insurance proceeds from estate tax, consider owning your insurance in an irrevocable life insurance trust (“ILIT”).

Approaching an ILIT

Many people create an ILIT to avoid the complications of estate taxes. In an ILIT, you designate the trust as the owner of the life insurance policy at the time the coverage is acquired or by transferring a pre-existing plan to the trust.

The trust must be irrevocable. In essence, you must relinquish all control over the ILIT, including the ability to change beneficiaries or cancel the trust. Similarly, if you serve as the ILIT trustee, this may be seen as a breach of ownership that renders the trust void. The trustee can, however, be another member of your family or a qualified outsider.

As the principal beneficiary of the life insurance policy, you should almost always name the ILIT. The proceeds will be transferred to the ILIT after your death and held there until distributed to the trust's beneficiaries. Normally, this would be your spouse, children, grandchildren or other family members.

Incidents of Ownership Issues

If you don't own the policy, the life insurance policy's payouts are typically excluded from your taxable estate. However, if you have any "incidents of ownership," your life insurance payouts will be accounted for in your estate. If you have the authority to modify the policy, say by changing the beneficiaries or if you have access to the cash value for borrowing purposes, it is regarded as an incident of ownership.

Avoiding ILIT Pitfalls

When transferring a life insurance policy to an ILIT, there are a few risks to consider. The proceeds from an existing policy transferred to the ILIT will be included as part of your taxable estate if you pass away within three years of the transfer. One way to prevent this outcome is to have the ILIT buy the life insurance policy and then gradually fund the trust with enough cash to cover the payments.

Remember, transferring an existing policy to an ILIT is regarded as a taxable gift. Furthermore, any additional transfers to the trust to pay premiums, for example, would likewise be regarded as gifts. Your applicable gift and estate tax exemptions could be used to protect the gifts from taxation. In addition, your annual exclusions ($16,000 in 2022 and $17,000 in 2023) could be used to shelter the gifts from the gift tax if the beneficiaries have the present right to withdraw such contributions from the trust. These rights are commonly referred to as "Crummey powers."

Currently, the highest estate tax rate is 40%. However, in 2022, you may shield up to $12.06 million of the assets from federal gift and estate tax using your gift and estate tax exemption. This exemption increases to $12.92 million in 2023. If Congress does nothing, however, the exemption will return to $5 million (indexed for inflation) after 2025.

The Final Word

An ILIT is largely used as a financial planning and estate planning technique to safeguard assets from being susceptible to estate taxes, especially a sizable life insurance death benefit. Your beneficiaries' final inheritance can be significantly less if your estate is liable for estate taxes when you pass away. Even after passing away, most individuals prefer not to pay any more taxes than they absolutely must. As such, effective estate planning is essential for individuals whose wealth may be subject to estate taxes.

If you have a high net worth and wish to lower your estate taxes, an ILIT may be a good option for you and your family. To find out how an ILIT could be appropriate for your estate plan, speak with an estate planning professional.

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Scott E. Testa

Scott Testa is a Tax Partner and a leader in the Trusts and Estates practice within the Private Client Services Group.

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