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How Life Insurance Impacts Estate Taxes
Did you know that life insurance proceeds payable on an insureds death are subject to federal and state estate taxes unless the beneficiary is a surviving spouse? Even though life insurance proceeds, for the most part, are not subject to income taxes, they will be subject to estate taxes if the insured owns the policy.
A technique that allows the life insurance proceeds to escape this exposure to estate taxes is to have an Irrevocable Trust (“ILIT”) purchase the life insurance and be named as the beneficiary of the proceeds. Since the insured is not the owner of the policy, the death benefit is not an asset of the estate of the insured individual and is, therefore, not subject to estate taxes. The same technique can also be used for policies that an insured currently owns. The insured individual can make a gift of the policy to the ILIT and, so long as the insured survives for three years after the gift of the policy (a waiting period imposed by the tax laws for gifts of insurance policies), the death benefit will not be subject to any estate taxes.
Both the transfer of ownership of an existing policy to the ILIT and the insureds ongoing payment of the insurance premiums may have gift tax consequences. These consequences may be minimized or eliminax0ted with proper drafting of the trust agreement.
What has been accomplished by this technique? The ILIT will receive the life insurance proceeds without any income taxes or estate taxes being assessed and the entire death benefit is available for the financial security of the insureds family. The irrevocable life insurance trust is an excellent technique to shelter life insurance proceeds from exposure to estate taxes, particularly for an individual with a net worth, exclusive of the life insurance, in excess of the current $2 million federal estate tax exemption.