A primary benefit for owning a life insurance policy is to generate a significant amount of money payable to your heirs if you die.
Included in this benefit is giving your loved ones a federal income tax free benefit when proceeds are paid directly to the beneficiary.
Even though life insurance proceeds are not subject to federal taxes, there could be estate taxes owed before your loved ones receive the benefit.
Ownership at the time of your death determines whether the life insurance policy becomes as asset of your estate.
Typically, if you are the owner and you die, the proceeds of the policy is included in your estate for tax purposes. This is the case even though the proceeds go to the beneficiary tax free.
Part of your estate planning strategy should include creating an irrevocable life insurance trust. Basically, you have more control over how the money from your insurance policies is paid with an irrevocable life insurance trust.
This type of trust removes proceeds of the policy from your taxable estate assets and leaves more for your loved ones. In essence, you are transferring ownership of the life insurance policy to make sure few, if any, taxes are not owed.
Completing an ownership transfer has several requirements. First, you cannot be the trustee of the irrevocable trust. Second, you will want to name a suitable trustee whom you trust and is willing to serve in this capacity. Finally, you usually are not allowed to change the terms established in the trust. This includes the originally named beneficiaries of the policy.
How the Irrevocable Trust is Established
There are two ways that an irrevocable life insurance trust can be established. One way is to transfer an existing insurance policy to a new trust. Policy transfer must occur at least three years prior to death to avoid taxation. Another way is to create a new family trust and purchase a new life insurance policy through the trust.
Ideally, you should hire an estate planning professional who can assist with drafting the appropriate documents. Questions to consider in the process include:
- Who is a responsible person that you can name as the trustee?
- Who is the beneficiary of the life insurance policy?
- Will you buy a new policy or transfer an existing policy for the trust?
IRS Regulatory Considerations
The IRS has regulatory requirements that determine who is the owner of a life insurance policy. Upon the death of the insured person, ownership is determined by the three-year rule, which subjects life insurance policies to federal estate taxes if the insured dies within that time frame. The life insurance policy is classified as a gift and is applicable whether the ownership of the policy transfers or a new irrevocable trust is established.
Another regulation from the IRS involves verifying incidents of ownership once you transfer the policy. As mentioned above, you must forfeit your rights to change beneficiaries, borrow money against the policy or cancel the policy. Additionally, you cannot continue to make premium payments that keep the life insurance policy in force.
Basically, while you control how much money your loved ones receive, you cannot control how the policy is executed once the trust is established. The IRS will look for areas where you may have controlled decisions about the policy after the trust was set up. If there are signs that you conducted ownership responsibilities, the tax advantage of transferring the policy is negated.
Funding the Irrevocable Life Insurance Trust
When the trust is funded by transferring existing life insurance policies, this is considered making a gift based on the cash value at the time the transfer occurred. In some circumstances, you might need to use a lifetime gift tax exemption to avoid paying taxes for the tax year that the trust was established.
In other situations, transferred assets are still subject to the gift tax when the cash value of the life insurance policy exceeds $13,000. Generally, gift taxes are due upon the insured’s death. This may occur even if the policy transfer meets all requirements.
As with all trusts, an irrevocable life insurance trust could have some flexibility in what happens to the income and the conditions in which the principal is paid to beneficiaries. The structure of the trust can have significant tax implications. Therefore, it is recommended that you address any concerns with an estate planning professional to ensure your wishes are carried out.
By creating an irrevocable life insurance trust, you can transfer the full amount of proceeds to the beneficiary without paying estate taxes. Proceeds from the insurance policy can become an income stream for your loved ones; the proceeds could also be used to pay expenses related to your estate.
Ownership of the life insurance policy determines how proceeds are handled. Your heirs can have asset protection against potential lawsuits or other questionable issues that may arise after your death. Discussing your options with an estate planning professional will help in deciding the best structure for the trust and in avoiding estate tax consequences.