If the proceeds from life insurance policies that you own, when combined with the value of your other assets, exceed the $1.4 million exemption from Minnesota’s estate tax for persons dying in 2015, then you may want to consider an Irrevocable Life Insurance Trust (ILIT).
When you die, the proceeds paid to your beneficiaries under any life insurance policy that you own are counted as part of your assets for estate tax purposes even though you personally never got the benefit of the life insurance payout. It doesn’t matter if the life insurance was whole life, term life or another type.
However, an ILIT can keep the life insurance proceeds out of your estate for estate tax purposes while still allowing your family to benefit from the life insurance proceeds.
The difference in tax treatment hinges on who owns the life insurance policy. When you are the owner of the life insurance policy – the typical scenario — the life insurance proceeds are included in the value of your estate. However, with an ILIT, the trustee of the ILIT is the owner of the policy, which allows the life insurance proceeds to be excluded from your estate.
Your existing life insurance policy can be placed into an ILIT, or you can buy a new policy. If you use an existing life insurance policy to fund an ILIT, you must live three years beyond the transfer date for the transfer to be effective. There is no three-year look back for a new policy that the trustee of your ILIT applies for and owns.
“Irrevocable” means what it says. You have very limited control over the ILIT and insurance policy once it is set up. You can’t change the beneficiary. You can’t have a right to withdraw the cash value. You can’t be the trustee, and your spouse should not be the trustee either. Adult children or other relatives could be the trustee. A corporate trustee may also be appointed by you.
Here’s how an ILIT works:
You, as the insured, will gift to the ILIT sufficient dollars each year to be used by the trustee of the ILIT to pay the annual insurance premium. If the annual premium is greater than the annual $14,000 gift tax exclusion, annual gift tax returns will be required.
So-called “Crummey notices” will be needed each year to give the ILIT beneficiaries the right to withdraw, within a certain time frame, their share of the money that was gifted by you to the ILIT trustee and intended for payment of the insurance premium. Since your gift is really for the insurance premium, you don’t really want the beneficiaries to exercise their withdrawal power. But they could! The fact that the beneficiaries have the opportunity to withdraw their share of the intended premium payment creates tax advantages that make the ILIT work under IRS rules. (Crummey notices are named after a Mr. Crummey who won a fight with the IRS several years ago).
The ILIT is a separate taxpayer and will be taxed on any trust income. Typically, however, there won’t be any income if the only asset of the trust is a life insurance policy.
ILITS are more complicated than the typical revocable trust. Seek the guidance of an estate planning attorney to determine if an ILIT makes sense for you, given your asset levels and your goals.
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