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A hidden source of estate tax and what to do about it

On Behalf of | Aug 18, 2017 | Blog |

When you accumulate a significant amount of wealth, part of your estate planning process is to limit your taxable estate. You work to make sure that your family will receive the maximum benefit from your estate as possible after your death.

You may have even created trusts and filled out your beneficiary designation forms. With all of your preparations, however, you may have missed that the IRS adds the proceeds from life insurance policies to your taxable estate. The value of the policy could throw a very expensive monkey wrench into your estate plan. Fortunately, there may be a way to correct the problem.

The irrevocable life insurance trust

Did you know that you could create a trust that removes your life insurance policy from your taxable estate? An irrevocable life insurance trust owns the insurance policy on your life. Once you create and fund an ILIT, you cannot change, modify or cancel it since it’s irrevocable. Either the trust can purchase a life insurance policy, or it can take over ownership of your existing policy.

Unlike some other trusts, you cannot serve as the trustee of your ILIT. If you do, you retain control over the policy. According to the IRS, this creates an “incidents of ownership,” which means that the IRS counts it in your taxable estate upon your death. The trustee can be someone close in familial relationship such as a spouse, child or sibling, and that will satisfy the IRS requirement and remove it from your personal estate.

ILIT beneficiaries

Not only does your ILIT own your life insurance policy, but it is also the designated beneficiary of it. Upon your death, the proceeds from the policy go into the trust. Then, whomever you named as the beneficiary or beneficiaries to the ILIT will receive periodic distributions from the trust in accordance with your instructions.

As an added bonus, if your spouse is the one receiving periodic distributions from the ILIT, he or she will not have to add the proceeds to his or her taxable estate.

There could be some issues, however

The biggest gamble you take with an ILIT is that you will survive past three years of creating and funding the trust. If you die before the expiration of that time limit, the IRS adds the value of the life insurance policy back into your estate. To get around this potential problem, the trust needs to purchase the policy, and you need to fund it with enough money to cover the premiums as needed, which the IRS may view as a gift for tax purposes.

Fixing this potential problem requires the trustee to send a “Crummey” letter to the trust’s beneficiary each time you add money to the trust. This letter allows the beneficiary to request a distribution of those funds. However, since the policy will lapse without the payments, most beneficiaries decline the distribution. You also cannot cancel the trust since it is irrevocable. Well, technically, that is true, but if you let the policy lapse, there is no use for the trust.

Setting up this kind of trust may require the assistance of someone experienced in creating one. That individual could also answer any other questions you may have about this type of trust.


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