Many Massachusetts families choose to get life insurance policies thinking that those policies are a way to provide for their loved ones. The problem is that the death benefit from a life insurance policy could also be that one asset that triggers the Massachusetts estate tax — resulting in a portion of your money not getting to your loved ones.
The fact is that the proceeds from life insurance policies owned at your death will be included in your estate for estate tax purposes. The Massachusetts estate tax exemption is $1 million. If your assets at death are above $1 million, including your life insurance, you’ll be taxed on the entire amount. The issue arises when it’s your life insurance proceeds that push your estate value over the $1 million. The key is knowing how to avoid entangling life insurance in your estate.
If a policy owner can withdraw the cash value of an insurance policy and change the beneficiary, then the policy owner is deemed to have “incidents of ownership” over the proceeds, and the IRS and state taxing authorities can then tax the proceeds at death. This entanglement can be avoided by using an Irrevocable Life Insurance Trust.
An Irrevocable Life Insurance Trust (ILIT)
An ILIT is a type of irrevocable trust that is specifically designed to hold and own life insurance policies. Once your attorney drafts the ILIT, you can 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.
Upon transferring your policy to the ILIT, you’ll have given up all of your incidents of ownership over the policies. Since you’ll no longer own the policies, they won’t be counted as part of your estate, thus reducing your estate tax liability.
Who Are the Beneficiaries of an ILIT?
An ILIT is designated as the primary beneficiary of your life insurance policies, so after you die the insurance proceeds will be deposited into the ILIT. It will then be held in trust for whomever you choose. You can set it up so the policy’s proceeds get paid out immediately, over time (e.g., monthly, annually), or when beneficiaries attain certain milestones (e.g., graduate from college, become a certain age). An ILIT gives you the power to ensure that the proceeds from your life insurance policy are used in the best possible way on behalf of your loved ones.
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. This alone can end up saving you tens of thousands of dollars in estate taxes.
The Three-Year Rule
The Internal Revenue Code (IRC) treats the transfer of a life insurance policy to an ILIT as a gift. The IRC says that gifts made within three years of an insured’s death may be counted toward their estate. That means that a life insurance policy transferred to an ILIT within three years of the owner’s death will be included in the insured’s estate. So it’s important to create the ILIT early so that hopefully more than three years pass before the insured’s death.