Irrevocable Insurance Trusts and Taxes
A key benefit of an ILIT is the ability to reduce estate taxation. This protects your policy death benefit and cash value that grows over time. This may lead you to ask, “How exactly does an ILIT reduce estate taxes?”
An ILIT reduces estate taxes because it allows you and your family to avoid incidents of ownership by allowing your trust to own your policy. Since ownership is in the name of the trust, the cash benefits of your policy will not be included in your estate. You don’t want to make the mistake of choosing another member of your family as the owner of your policy, as the risk of estate taxes will then be transferred to them.
If your family has to pay estate taxes after you transfer ownership to the trust, you can further reduce the tax costs by using your trust to purchase more policies. This is a good idea because as the owner, the life insurance proceeds will not be included in income tax, funds are available sooner after the insured passes, and your family avoids probate court.
Universal life insurance policies are ideal for this particular situation. Universal life policies are used as an investment tool and have more financial flexibility than other types of life insurance policies. Because you can “dump” lump sums of money into these policies, having an ILIT own the policy will save those investments from a large tax bill.
In 2020, the federal estate tax exemption applies to estates over $11.58 million. While this tax cut will help you on the federal level, each state has its own exemptions. Many states begin taxing estates worth $1 million or less. Reaching $1 million in assets is more common than many people consider. With taxes ranging from 18 to 40 percent, placing part or all of your family’s wealth into a trust will make a huge difference financially.
For example, a grantor with a $500,000 life insurance policy and a home worth $500,000 would be subject to a tax consequence. In the event of their death, the beneficiaries would be responsible for paying those taxes. Transferring the proceeds from your life insurance policy into an ILIT will protect your family from high tax percentages. It’s vital to know how your state operates to ensure you receive any estate tax exemption you qualify for.
If your life insurance policy is owned by your trust, the death benefit will not be included in any state or federal gift tax.
The tax rate is also reduced when your trust buys a new policy. Your selected trustee will buy the policy on behalf of the trust, and you will provide the funds to purchase the new policy. This cash transfer between yourself and the trustee is subject to a gift tax. It helps to know that you can make tax-free gifts of up to $13,000 per year or $26,000 if you make a transaction with your spouse.
Crummey power is a technique that helps people receive or give a gift without paying the usual gift tax. Crummey power is primarily used for putting funds into your trust as a “gift.” This makes you eligible for the annual federal gift tax exclusion. This exclusion applies to deposits up to $15,000.
An irrevocable life insurance trust is one of the best financial products available. It is essential for estate tax purposes. You’ll be adding generations of protection to your family. There is no limit on when you can purchase an ILIT. You can buy one at any time and ensure you haven’t left out any key details. Don’t be afraid to weigh different options and have discussions with your family about what’s best for everyone’s financial future.