While benefits received from a life insurance policy are not treated as income for tax purposes, if the life insurance policy was in the deceased’s possession within three years of his death above the inheritance tax threshold, the deceased’s estate will be taxed at the rate of the insurance proceeds. Okay, now in plain language. If you buy life insurance for your own life, fund the policy throughout your life, and leave the proceeds to your spouse or other family member, they will owe large taxes. So what can you do to avoid this?
Creating an irrevocable life insurance trust (or “ILIT”) protects your family from the burden of inheritance taxes when they receive life insurance policy benefits. This inheritance tax saving can be achieved either by the insured forming an ILIT and passing on existing life insurance policies to the trust, or by the trust itself purchasing a new policy for the life of the insured. Insurance is excluded from the insured’s estate because the insured does not own the policy at the time of death.
There are three requirements: (1) the insured must not own or retain any ownership interest in the insurance, (2) the proceeds must be paid to the trust and not to the estate, and (3) if policies are given by the insured to the trust the insured must survive the donation by 3 years. To avoid gift tax consequences, simply mortgage the existing life insurance policy at the equity/value that the policy has already achieved since inception.
An ILIT also offers the benefit of providing information on who gets the money, at what age they get the money, and under what conditions they can get the money. For example, you don’t want your 7-year-old to inherit $2 million at once. How much candy and video games do they actually need? Instead, ILIT can appoint a trustee and provide for the child’s needs until the child reaches an appropriate age for inheritance, e.g. B. 18, 21 or 25. You can see that your child is cared for, but not given the opportunity to frivolously squander the inheritance.