While discussing planning strategies with a client last week, he mentioned that he and his wife have been gifting $28,000 a year to each of their two kids—the maximum amount they’re allowed to give without having to file a gift tax return. This couple—let’s call them Charles and Jacqueline—had chosen this option because if they were to die today, their estate would be substantially taxed. By passing this money to their kids, they were providing them with enough money to cover the estate taxes while also reducing the size of their taxable estate.
But we had a better idea: Instead of gifting $28,000 each year to both kids, who generally keep the money in their bank accounts where the amount doesn’t grow, why not take the same $56,000 and use it to fund a life insurance policy? Based on our projection, and the fact that this couple is in their early 60s, that annual premium could buy a nearly $4 million policy. Better yet, all of that money would pass tax-free and without being exposed to estate taxes if they used an Irrevocable Life Insurance Trust (ILIT).
How Does an ILIT Work?
It’s important to be aware that this strategy requires following specific rules in order for it to work properly. For example, to keep the life insurance proceeds outside of your estate, you can’t own the policy. Why not? Because any assets you personally own at death will be subject to estate taxation. This includes any life insurance policies you own, even if it’s held inside a revocable trust, in which case you still maintain control of the assets. However, an ILIT is an irrevocable form of trust, meaning it’s a separate entity. This means you would relinquish control of the assets placed inside the trust.
Here is how the ILIT would work in the above example: Charles and Jacqueline create the ILIT and name their two kids as co-trustees and co-beneficiaries of the trust. The kids then apply for life insurance with Charles as the insured and the ILIT as the sole beneficiary. Each year, Charles and Jacqueline would gift $56,000 to the trust and the kids, as trustees, would pay the policy premiums. Down the road, when Charles passes away, the death benefit would be paid to the trust and distributed to the beneficiaries according to the language of the trust. There are some other technical details but, in a nutshell, this is how the process works.
The Benefits of an Irrevocable Life Insurance Trust
In this case, the ILIT would meet Charles and Jacqueline’s needs in many ways: first, and perhaps most importantly, it creates an ownership entity, which keeps the life insurance proceeds outside of their gross estate, so the eventual payout won’t be subject to taxation. And while the gifting strategy continues to remove $56,000 each year from their estate while they are still alive, if they gift 20 premium payments, that removes over $1 million from the estate, which reduces that amount that can be taxed. What’s more, the language of the trust allows Charles and his wife to specify how the distributions should be made. For some, this may be immediate payments, or for others, this could be a multi-generational wealth transfer strategy.
The other benefits are mostly specific to the life insurance vehicle: the death benefit payment would be tax-free, as it most often is with life insurance policies. Also, the rate of return for the investment is guaranteed and not subject to daily news headlines like stocks and bonds, which can fluctuate wildly over time. Also, if for some reason the insured (Charles) were to die early—say at 70 years old—an investment of only a few hundred thousand dollars would still yield a multi-million-dollar payment.
Don’t Burden Your Heirs with Unnecessary Estate Taxes
All of this makes an ILIT a very efficient estate planning tool. While many people realize that life insurance proceeds can pass along tax-free, they don’t think about the fact that those same proceeds may be included in their gross estate for estate tax purposes. This means they’re subjecting their heirs to enormous (and unnecessary) taxation.
At Howard Kaye Insurance, we have decades of experience setting up these strategies for our clients. Our experts can create an estate planning strategy using life insurance that will maximize your legacy and minimize your tax exposure. Contact us today to learn more about how we can help.