With the variety of life insurance options available in today’s market, the use of life insurance as an estate planning tool has increased dramatically. However, the tax effects of the life insurance policy many times become an issue that present problems for the unsuspecting estate planning client. However, one valuable option exists for addressing estate tax consequences of life insurance policies.

The value of a life insurance policy is included in the estate for estate tax purposes of the person who owns the policy. For instance, when Husband and Wife own a policy for $500,000 on Husband’s life, the proceeds of the policy ($500,000) are included in Husband’s taxable estate upon his death. As a result, the value of a large life insurance policy can very often force someone into the position of owing estate taxes at the time of death.

An Irrevocable Life Insurance Trust (an “ILIT”) can be used to avoid the tax problems associated with life insurance policities. In an ILIT, the ownership of the life insurance policy is transferred into the Trust, and the trust thereafter pays the premiums on the policy. When the insured person dies, the proceeds of the policy are payable to the Trust, rather than to the insured’s family. Because the policy is not owned by the decedent at the time of his death, the proceeds are not included in his gross estate for purposes of computing estate taxes.

Example: In 2002, Husband and Wife transfer a $1 million life insurance policy on Husband’s life to the ILIT that they establish. The terms of the Trust state that the trust property shall be held until the last to die of the Husband and Wife, and then the property shall be divided between their children equally. Husband dies in January 2006, and Wife dies 3 months later.

Because the life insurance policy on Husband’s life was owned by the Trust at the time of his death, the $1 million is not included in his estate for computing estate taxes.

Items to Note:

  1. IRS rules related to life insurance policies states that any policy transferred to another person or to a trust within the 3 years prior to the owner’s date of death will be brought back and included as part of the Decedent’s estate for tax purposes. Therefore, anyone creating an ILIT must out-live the creation of the Trust for at least 3 years if they are transferring an existing life insurance policy into the Trust.
  2. Premiums on the life insurance policies in an ILIT are typically paid using gifts made to the Trust from the original owners of the policy. In the Example above, Husband and Wife would make gifts of the annual insurance premiums to the Trust, and then trustee would use those gifts to pay the premiums on the policy. The gifts to the Trust must qualify under the Crummey Trust rules.
  3. An ILIT can be created and funded with a brand new life insurance policy instead of transferring an existing policy to the Trust.