While most estates are not subject to the federal estate tax, those estates valued in excess of $5.49 million in the year 2017 are. To compensate for these taxes, those concerned about passing on all they’re worth, often purchase life insurance to provide additional funds from which to pay these taxes. Without your knowing it, the life insurance may just be adding to the tax it was meant to pay.
In determining whether your estate exceeds the $5.49 million threshold, you include the fair market value of all your assets. This includes real estate, stocks, bonds, all retirement accounts and, generally, the proceeds from your life insurance. To keep the life insurance proceeds out of your taxable estate, you must not be the owner of the policy, and the beneficiary must not be your estate. Sounds simple enough, but if you’re not the owner, who will be? If you choose your spouse, the proceeds may not be included in your estate, but what’s left over will probably be taxed when your spouse dies. The key, therefore, is to keep the insurance proceeds from being taxed in either your or your spouse’s estate. To accomplish this, estate planners have developed the so-called irrevocable life insurance trust.
The problem with the irrevocable life insurance trust is that the IRS doesn’t like them, and has successfully challenged them in court. The good news, however, is that recent cases have approved their use if you do things right.
The first “right” thing to do is to never own your insurance policy in the first place. As such, if you are purchasing a new policy, you should not be designated as the owner or the applicant. You should first set up the trust, and have the trustee apply for the policy on your life.
Second on the list of “right” things to do is to have the trust drawn with attention to every detail. Your trustee shouldn’t be directed to purchase insurance on your life but, rather, life insurance should be just one of the permissible investment vehicles. In addition, make it clear that the trustee has all of the ownership rights in the policy.
The final thing is to make sure that the trust has appropriate language that will enable you to make tax-free gifts to the trust, so that the insurance premiums can be paid.
When it comes to the irrevocable life insurance trust, doing things right means paying attention to detail and following all of the rules. Doing things wrong in 2017 means that Uncle Sam will take 40% of your life insurance. As such, the additional expenses in preparing such a trust should be well worth the cost.