Utilization of a life insurance policy can be a very effective estate planning strategy.  Life insurance proceeds can help to financially take care of your loved ones and can bring liquidity to an otherwise illiquid estate.  For example, if your estate is large enough to be subject to the estate tax, but is comprised of illiquid assets like real estate or business interests, your trustee or personal representative may be forced to sell some assets you may not have wanted to be sold, in order to pay the estate tax due.  Life insurance can help prevent this problem, however, if you decide to utilize this strategy, it is important that you consider taking steps to prevent the life insurance proceeds from being included in the taxable estate.

Most people understand that life insurance proceeds are not taxable to the recipient under the INCOME TAX.  However, many fail to realize that life insurance proceeds (the death benefits if the deceased was the insured, or the cash value if the insured was someone other than the deceased) are taxable under the ESTATE TAX if the deceased owned the policy or had “incidents of ownership” over the policy.  “Incidents of ownership” includes, among other things, the power to alter the policy or change beneficiary designations, the power to assign the policy, the power to borrow against the policy, the power to cancel or surrender the policy, and the right to use the policy to collateralize a loan.

You can avoid having “incidents of ownership” over a life insurance policy by setting up an irrevocable life insurance trust (an “ILIT”) to hold the policy and to make premium payments on the policy.  If set up properly, an ILIT can ensure that the proceeds from the life insurance policy are not included in your taxable estate.  However, there are very strict rules for ILITs, regarding trustee powers and authority, and how the trust is originally funded.  Additionally, you will most likely be required to file a gift tax return for the transfer of the life insurance policy to the ILIT. If you are going to set up an ILIT, you should consult with an experienced estate planning attorney to make sure all of the requirements are complied with.

For additional reading:

QDOT Trusts

QTIP Trusts (Marital Trusts)

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