People often think of life insurance as “tax-free,” but that’s not entirely true. Life insurance proceeds generally are income-tax-free to your beneficiaries, but if you own the policy at your death, the proceeds may be subject to estate taxes. One of the best ways to keep life insurance out of your taxable estate is to place the policy in an irrevocable life insurance trust (ILIT).
If you’re thinking about setting up an ILIT for an existing policy, consider doing so before the end of the year, particularly if it’s a high-cash-value policy.
Contributing a life insurance policy to an ILIT constitutes a taxable gift to the trust beneficiaries of the policy’s fair market value (which generally approximates its cash value). Making the gift this year allows you to take advantage of the record-high gift tax exemption.
The exemption stands at $5.12 million for 2012, but it’s scheduled to drop to $1 million next year. And while, as of this writing, it’s not yet certain what Congress will do about gift and estate taxes, many believe that the exemption amount has reached its peak.
Keep in mind that future ILIT contributions to cover premium payments will be taxable gifts. You may, however, be able to apply your annual gift tax exclusion (currently, $13,000; $26,000 for married couples splitting gifts) to reduce or eliminate the tax — provided the ILIT is structured appropriately and certain other requirements are met. Alternatively, if you can afford it, you might take advantage of the $5.12 million exemption to “front-load” the ILIT with cash to fund future premium payments.
Giving up ownership
To remove a life insurance policy from your taxable estate, simply transferring the policy to an ILIT isn’t enough. You must also relinquish all “incidents of ownership,” such as the power to change or add beneficiaries; to assign, surrender or cancel the policy; to borrow against the policy’s cash value; or to pledge the policy as security for a loan. If you retain any incidents of ownership, the insurance proceeds will still be included in your estate and may be subject to estate taxes, depending on the size of your estate and your available estate tax exemption.
Also, be aware of the “three-year rule,” under which the proceeds are pulled back into your taxable estate if you die within three years after transferring an existing policy to an ILIT. In light of this rule, the safest strategy is to establish the ILIT first and have it acquire an insurance policy on your life. But if you already own a policy, the sooner you transfer it to an ILIT, the greater the chances that you’ll successfully remove it from your estate.
An ILIT offers significant tax benefits, but it also has some significant limitations. As mentioned, after you transfer a policy to the trust, you can no longer change or add beneficiaries; assign, surrender or cancel the policy; or borrow against or withdraw from the policy’s cash value. In addition, you’re not allowed to alter the trust’s terms or act as trustee.
Nevertheless, there are some techniques available to build flexibility into an ILIT. For example, you can design the trust to:
Adapt to changing circumstances,
Provide that children or grandchildren born after you establish the trust be automatically added as beneficiaries, and
Give the trustee the power to remove beneficiaries under certain circumstances (such as removing your daughter-in-law if she divorces your son).
You can also establish conditions for distributing funds from the ILIT. For example, you might instruct the trustee to withhold funds from a beneficiary who drops out of school or develops a substance abuse problem.
Another strategy is to appoint a “trust protector.” A trust protector is a sort of super-trustee who has the power to remove the trustee, amend the trust or take other actions to ensure that the ILIT achieves your objectives in light of changing laws or circumstances.
And with careful planning, it’s possible to still tap your policy’s cash value under certain circumstances. For example, you can design the ILIT so that it permits the trustee to borrow against or withdraw from the policy’s cash value and distribute the funds to your spouse or other beneficiaries for their support. (Bear in mind that the cash value in a life insurance policy is accessed through policy loans, which accrue interest at the current rate, and withdrawals. Loans and withdrawals will decrease the cash surrender value and death benefit.)
Another option is to retain the right to swap the life insurance policy in the trust for other assets of equivalent value. In a recent ruling, the IRS gave its blessing to this technique. (See the sidebar “IRS allows grantor to recover policy from ILIT.”)
Life insurance is a powerful estate planning tool. It creates an instant source of wealth and liquidity to meet your family’s financial needs after you’re gone. To shield proceeds from estate taxes, consider transferring your policy to an ILIT. And, if possible, complete the transfer this year to minimize gift taxes on the policy’s current value.
Sidebar: IRS allows grantor to recover policy from ILIT
Until recently, it was uncertain whether a grantor’s power to acquire a life insurance policy from an ILIT by substituting other assets of equivalent value is an “incident of ownership” that causes the proceeds to be included in the grantor’s taxable estate.
Late last year, the IRS issued Revenue Ruling 2011-28, providing that the retention of this right in a nonfiduciary capacity isn’t, by itself, an incident of ownership. Under the ruling, to avoid estate tax inclusion, the following conditions must be met:
The grantor must not serve as trustee.
The trustee must have a fiduciary obligation to ensure that the substituted assets are of equivalent value.
The substitution power cannot be exercised in a manner that shifts benefits among the ILIT’s beneficiaries.
The ruling makes ILITs more attractive by permitting a grantor to build additional flexibility into the trust. For example, the power to substitute assets might allow a grantor to gain access to the policy’s cash value by swapping it for illiquid assets of equivalent value. It also makes it possible to cancel an expensive policy that’s no longer needed.