The Heritage Law Center, LLC Blog

Without an Irrevocable Life Insurance Trust Your Insurance May Cost You

POSTED ON: February 4, 2011

Life insurance policies can be a great way to provide for your loved ones after you are gone, however they can also have some unintended negative consequences on your estate plan. Most people think of life insurance as simply a bundle of cash that will go to your survivors, but this is only partly true. While your survivors will see some of that money, the proceeds from life insurance policies that you own at death will be included your estate for estate tax purposes.

If you own a life insurance policy it will be fully subject to tax as part of your estate if (1) the proceeds of the policy are payable directly or indirectly to your estate, or (2) if you, while alive, held any ownership in the property, such as the right to change a beneficiary, surrender or cancel the policy or borrow against the policy.

Also, if you leave life insurance proceeds to someone other than your spouse, the proceeds will be taxed as being part of your estate. If you do leave the proceeds to your spouse then they will not be considered part of your estate, but could be taxed as part of your spouse’s estate.

This can have a substantial impact on your estate and may result in a loss of value for your insurance policy. For example, if you have a policy worth $1,000,000 at your death, the insurance proceeds will in effect use up your entire Massachusetts state tax exemption and a sizable chunk of your federal estate tax exemption.

One way to avoid this outcome is to establish 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 a life insurance policy is placed in an ILIT, it is considered to have no ‘owner.’ Therefore, it will not be taxed as part of your estate. It should be noted, however, that this also means you can not change or cancel the life insurance policy.

Once the ILIT has been set up you can have the trustees (usually your spouse and/or children) purchase the insurance plan on your behalf. If you already have a life insurance policy, ownership of the policy can be transferred to the ILIT.

Typically the ILIT will also be designated as the primary beneficiary of your life insurance policies. After you die, the insurance proceeds will be 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. This structure will keep the money out of both your and your family’s estate for tax purposes so that your beneficiaries can receive the full benefit of these resources. An ILIT can also help your family with cash to pay your estate tax bill while not adding to your overall tax burden.

Speak with a Massachusetts estate planning attorney to discuss whether an ILIT could benefit you.