Contrary to what many people think, the proceeds of life insurance policies are not tax free. That does not necessarily mean that an estate will have to pay tax on the proceeds though.
An irrevocable life insurance trust (ILIT) is a useful estate planning tool to reduce tax liabilities. ILITs are designed to own life insurance policies. They are not just for wealthy people. People with modest means can use them—including people with virtually no assets other than a sufficiently large life insurance policy in a state with an estate or inheritance tax.
Life insurance provides a source of liquid assets to pay an estate’s expenses and taxes after a breadwinner dies. It can be used for business purposes (e.g., to fund the buyout of a deceased partner’s equity interest) or to benefit an insured’s dependents. The beneficiaries can use the cash so they do not have to sell property or make painful sacrifices.
When someone (i.e., the decedent) dies, most of the person’s assets are included in the “gross taxable estate.” Its value determines whether the estate owes taxes to the IRS, the state tax department, or both. Taxable assets include real estate, bank and brokerage accounts, and life insurance proceeds.
Most estate values fall far below the level needed to pay the federal estate tax. In contrast, in New York, the state’s estate tax is levied on all gross taxable estates worth more than $1 million. Thus, if a policy pays more than $1 million, it will create a tax liability.
If an insured spouse dies, a surviving spouse does not have to pay an estate tax due to an unlimited marital deduction. In contrast, if unmarried insured dies, the life insurance policy payout may be taxed depending on the amount that the policy pays and estate tax threshold in the state.
Suppose a single parent has virtually no assets other than a $1.5 million dollar policy. Her dependents (e.g., her children, an elderly parent) are her beneficiaries. If she dies, the proceeds of the policy are $1.5 million. The first $1 million is exempt from the New York estate tax, but the next $500,000 is taxable. Based on the formula used in New York, her estate would have to pay almost $156,000 to the state. Thus, because she owned the policy in her own name, rather than in an ILIT, the government receives more than 10% of the money she thought would benefit her dependents.
The most efficient way to avoid this tax liability is to form an ILIT and for its trustee to purchase a policy that insures the life of the breadwinner. Often, however, people purchase life insurance before learning about ILITs. Thus, insureds may decide to transfer a life insurance policy into an ILIT, which becomes the new policy owner.
After the transfer, the policy is considered to be part of the estate until three years after the transfer is completed. Thus, if the insured dies within three years, the policy’s proceeds are taxable.
Transferring a life insurance policy may have gift tax implications. Thus, it is important to know the value of the policy, which is calculated under Treasury Department regulations. One’s insurance agent can provide a written estimate of the policy’s value, outstanding loans borrowed against it, and the amount one may still borrow. One may reduce or eliminate gift tax consequences by borrowing a portion of the policy’s cash value (thereby reducing its value) before transferring the policy.
To exclude the policy from one’s estate, the insured may not retain any “incidences of ownership.” These include the right to (1) borrow against the policy’s cash value, (2) name beneficiaries, and (3) assign the policy to another person. The insured should not serve as the trustee of the ILIT. Also, the insured should transfer money to a trust bank account so the trustee can pay the annual premium.
Editor’s note: This column does not constitute legal advice.
IRS Circular 230 Legend: Nothing in this column is intended to be and cannot be used to avoid U.S. federal, state, or local taxes. It was not written to promote any tax planning strategy or action. One should consult with one’s attorney and tax advisor to discuss one’s personal circumstances.
Bryan L. Berson, Esq. is an attorney and mediator at The Berson Firm, P.C., a commercial and civil law firm specializing in business law, real estate, mediation and litigation. His e-mail is firstname.lastname@example.org. Connect with The Berson Firm on Facebook and Bryan on LinkedIn.