While life insurance benefits are not treated as income for tax purposes, the deceased’s estate is taxed on any amount of insurance proceeds if the life insurance policy was owned by the deceased within three years of his death. above the inheritance tax limit. Okay, now in plain English. If you take out a life insurance policy for your own life, finance the policy during your lifetime and leave the proceeds to your spouse or other family member, they owe large taxes. So what can you do to prevent this?
Creating an irrevocable life insurance trust (or “ILIT”) protects your family from the burden of estate taxes in receiving the life insurance benefits. This savings on estate taxes can be achieved by the insured creating an ILIT and giving existing life insurance policies to the trust, or by buying the trust itself a new policy on the insured’s life. The insurance is excluded from the insured’s estate because the insured does not own the policy at the time of death.
There are three requirements: (1) the insured must not own or retain any property incidents in the insurance, (2) the proceeds must be paid to the trust rather than to the estate, and (3) if policies are issued by the insured to the trust, the insured must survive the gift for 3 years. To avoid any gift tax implications, simply borrow against the existing life insurance policy for the amount of equity/value already reached by the policy since its inception.
An ILIT also offers the advantage of instructing who gets the money, at what age they get the money, and under what conditions they can get the money. For example, you wouldn’t want your 7-year-old to inherit $2 million all at once. How many candy and video games do they really need? Instead, the ILIT can designate a trustee and pay for the child’s needs until they reach an appropriate age for inheritance, such as 18, 21, or 25. You can see your child being looked after, but not given the opportunity is made to spend the inheritance lightly.