Did you know that if your estate is large enough, up to 40% of your life insurance death benefits can be lost to federal estate tax?

Although life insurance proceeds are not subject to income tax, they are included in your taxable estate, and therefore can be subject to estate tax. To prevent the taxation of life insurance proceeds, many of our clients choose to purchase their life insurance policy using an Irrevocable Life Insurance Trust (ILIT), or gift their existing policy to an ILIT. 

If you think an ILIT sounds like a good option for you, here are the top 6 things you should know:

1. It takes 3 years to take effect.

   If you are gifting your existing life insurance policy into an ILIT, the policy must remain in the ILIT for three years before it is excluded from your estate and not subject to federal estate tax.

2. You don't need to be worth millions to reap the benefits.

   The Massachusetts estate tax exemption is only $1M, and if an estate's value is more than that amount - even one dollar more - the entire estate is subject to tax. It's surprisingly easy for an estate to exceed $1M when you consider the value of a home, pension, and other personal assets, including life insurance proceeds. If your estate is worth $1,000,001, you'll pay Massachusetts estate tax (up to 16%) on the entire amount.

3. You must relinquish control of the policy to a third party trustee.

   If you could revoke the trust and take back ownership of the policy, the proceeds would be treated as a taxable asset. Therefore, you must give up control of the policy to a third party trustee.

4. You can still pay the premiums yourself, but you'll need to do it indirectly.

   Since you must give up control of the policy, the trustee is responsible for payment of premiums. However, you may pay the premiums indirectly by gifting an equivalent amount into the trust when premiums are due. The trustee will then use those funds to pay the premiums.

5. You may be subject to gift tax.

   When you gift money into an ILIT, this is treated as a taxable gift to the beneficiaries of the trust (your children, for example). Fortunately, there is an annual exclusion against gift tax, which exempts the first $14,000 of taxable gifts each year to any beneficiary. However, the annual exclusion is only available if your beneficiaries have an opportunity to take outright ownership of the gift. To achieve this, you must issue a "Crummey notice" at least once per year to each beneficiary, which gives them a limited number of days (usually 30 or less) to claim their share. After this limited time period has expired, the trustee may proceed to pay the insurance premium with the funds.

6. The cash value of your policy remains accessible.

    One of the major benefits of permanent life insurance is the fact that you have access to the cash value buildup within the policy while you are still living. The same is true of an ILIT, although you'll need to go through your third party trustee. The trustee is permitted to borrow cash from the policy and loan it to you.

An ILIT can be a great way to protect your life insurance benefits from estate tax, but there are many factors to consider when deciding what is best for you and your family. For more information, please feel free to contact me directly, leave a comment below, or download our Irrevocable Life Insurance Trusts FAQ: