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The Heritage Law Center, LLC Blog

Life Insurance Trusts and Estate Taxes

POSTED ON: October 7, 2013

Life insurance is an important financial tool for many Massachusetts families, however, many don’t realize that the proceeds from life insurance policies owned at death will be included the owner’s estate for estate tax purposes. That’s right: even though you will never get to see or enjoy the payoff from your life insurance policy, you can still be taxed on it, reducing the amount of assets that can be passed to your loved ones.

The Massachusetts estate tax exemption is set at $1 million. If your assets at death are above this limit, including life insurance, you will be taxed on the entire amount. For a person with $1 million in their estate, this results in a rough tax liability of $100,000. The key to avoiding this outcome 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 will 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, or ILIT for short.

How Does an Irrevocable Life Insurance Trust Work?

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 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. Therefore, the value of the policy will not 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 that, after you die, the insurance proceeds will be deposited into the ILIT. It will then 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.

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 in estate taxes.