Many people aren't aware that all of the proceeds from life insurance policies that they own at death will be included their estate for estate tax purposes. This is because if the policy owner can withdraw the cash value and change the beneficiary, then the policy owner will be deemed to have incidents of ownership over the proceeds and the IRS and, if applicable, state taxing authorities, can then tax the proceeds at death.
Thus, if you own a $2,000,000 term life insurance policy at the time of your death, then the insurance proceeds will already use up more than half of your $3,500,000 exemption from federal estate taxes. The result is even worse if your state collects estate taxes since most state estate tax exemptions remain at or below $1,000,000.
How an Irrevocable Life Insurance Trust Works
One way to avoid the taxing of life insurance proceeds at death is to establish an Irrevocable Life Insurance Trust, or ILIT for short.
An ILIT is a type of irrevocable trust that is specifically designed to hold and own life insurance policies. Once the ILIT has been set up, you will transfer ownership of your life insurance policies to the Trustee of the ILIT. While you can't be a Trustee of the ILIT - otherwise you'll be deemed to have incidents of ownership in the life insurance - your spouse and/or children can be Trustees.
Once you've transferred ownership of the life insurance to the Trustee of the ILIT, you will have given up all of your incidents of ownership over the policies. Since you'll no longer own the policies, the proceeds can't be taxed in your estate when you die.
Who Are the Beneficiaries of an ILIT?
The ILIT will also be designated as the primary beneficiary of your life insurance policies. Thus, after you die, the insurance proceeds will be deposited into the ILIT and held in trust for the benefit of your spouse during his or her remaining lifetime, and then the balance will pass to your children or other beneficiaries. Aside from this, the ILIT can provide your family with a quick source of cash to pay your estate tax bill while at the same time not increase your overall estate tax burden.
Another benefit of the ILIT is that since the insurance proceeds will be held in trust for the benefit of your spouse instead of going directly to your spouse, the proceeds can't be taxed in your spouse's estate either.