Life insurance policies are a popular way to pass a significant amount of money on to your heirs, while protecting them from certain costs associated with a large inheritance.
Life insurance policies avoid probate, which can be expensive, but is there a way they can also be exempted from the federal estate tax? Executing an irrevocable life insurance trust (ILIT) might be one way to accomplish this goal.
How do ILITs work?
When you execute an ILIT, you place your life insurance policy in an irrevocable trust. Irrevocable trusts are managed by third-party trustees. They cannot be modified once created, so assets in an irrevocable trust cannot be removed from the trust.
If your life insurance policy is in an ILIT, you are still considered to be the insured party, but the trust is the party that owns the actual policy.
What are the benefits of an ILIT?
The primary benefit of an ILIT has to do with estate taxes. If you are single and your estate is worth $12.92 million or more, your estate will be subject to the federal estate tax. This can reduce the size of your inheritable estate.
Generally, no one wants their estate to be diminished through the estate tax. So, it is desirable to keep valuable assets outside of your estate and thus outside of the estate tax.
Life insurance policies in an ILIT are not counted as part of your estate for the purpose of qualifying for the estate tax. This is because the trust owns the policy, not you.
There is an exception. To keep a life insurance policy out of your taxable estate, you cannot have owned the policy yourself within three years of your death. This means the ILIT must be created and the policy transferred at least three years before you pass away.
If you have significant assets, you have important decisions to make when estate planning. You want to ensure as much of your estate is exempt from the federal estate tax as possible, so your heirs can inherit as much as possible. Some people find ILITs to be a good way to accomplish this goal.