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Wealth Planning News
Vol. II, No. 3
Why Give the IRS Any of Your
Many people think life insurance passes free of taxes. It does pass free of income taxes in most cases, but is subject to death taxes when the insured owner dies. In fact, life insurance is added to everything else you own and pushes an estate into the taxable range, or to higher rates of taxation.
Therefore, your loved ones might only receive part of the insurance payable on your death. Your Congressperson gets the other half, and if you like what Congress does, more than what your family might do, then do nothing to make your insurance tax-free when you die.
You can choose to make your life insurance pass free of death taxes, and your advisors should tell you how to do that. And you should listen to them unless you want your government to get a part of your life insurance when you die.
Tax Free Life Insurance
The way to allow insurance on your life to pass without taxes when you die is to avoid owning it, or having any of what the IRS calls "incidents of ownership." Sounds simple, doesn't it? So let's explore things you might think you could do on your own.
Spouse or Relative as Owner Fails
First, you might think of having your spouse own the insurance on your life. After all, you want it to go to her and then to your children. But wait. If your wife receives all your insurance proceeds, the proceeds are added to what she owns, such as her half of the total estate, and makes the insurance taxable when she dies. So your kids still might only receive part of your life insurance proceeds. Or she might die first, and leave ownership back to you.
So next you decide to have your adult son or daughter own your life insurance. You and your wife gift the premiums to them each year, and they use the money to pay for your life insurance. But if your son or daughter gets involved in some losing lawsuit or in a divorce they might lose all or part of the policy on your life. Or they might borrow against the policy, or need funds for their own needs and neglect to pay all premiums that come due with money you gift to them. They can also change the beneficiary to omit your spouse, or your other kids.
Finally, you decide to have your brother or some close friend own your life insurance. You and your spouse could gift money to them for premium payments. But again, they own and control the policy and could lose it in litigation, or fail to maintain it, or change the beneficiary designation to omit your spouse and your own kids.
The Sensible Solution is an ILIT
An ILIT is an acronym for an irrevocable life insurance trust. You can be the trustmaker and put down instructions to your Trustee about who should receive life insurance proceeds, and how and when. Usually these instructions will mirror the instructions you have chosen for your will or your living trust centered estate plan.
The Trustee does not personally own insurance on your life, and so cannot lose it in a lawsuit or divorce. Further, a Trustee is held to the highest standards of care known to the law, and is subject to stringent civil and even criminal penalties for theft or wrongdoing with what has been entrusted to the Trustee.
In This Issue
Why Give the IRS Any of Your Life Insurance?
Tax Free Life Insurance
The Sensible Solution is an ILIT
• Answers Require Experienced Counsel
• When to Solve the Tax Problem
• Paralysis of Analysis is Personal Malpractice
There are many issues to consider when designing an ILIT. Here are some examples:
Who can serve as Trustee? And what if you want to be able to change to some other Trustee? How can you get money to the Trustee so the Trustee can make the premium payments required for the life insurance? Is there any way to give you access to cash values that might build up in life insurance owned by the ILiT during your lifetime? What can you do if you later decide to change who will be able to receive the insurance proceeds after you die? What if one of your kids tries to murder you, can you disinherit that one from the ILIT? How can your spouse get any benefits from your life insurance if you die before your spouse? What type of control over the insurance policy or insurance proceeds can you have and still not subject the insurance proceeds to death taxes when you die? Should you put insurance you now own into an ILIT?
Answers Require Experienced Counsel
There are satisfactory answers to each of the questions posed above. But this is definitely not an area of the law for self-help, or for some “fill-in-the blank” drafting by someone with a computer and a basic form. There are usually ways to allow for a change of Trustee but it must be done right. There are many technical issues related to how to make gifts through the ILIT, without running into problems of using up any part of your lifetime gift tax exemption, or your GST exemption. There are ways to make the ILIT flexible so things can be changed.
When to Solve the Tax Problem
There is, however, a problem with putting existing life insurance into an ILIT. If you die within three years of doing so the insurance is still taxed because of a law that says such a late gift of an insurance policy was made in contemplation of death only to avoid death taxes. So it is best to make sure the ILIT is in place as applicant and owner for any new insurance on your life. And if you want to put any existing insurance into an ILIT do it sooner rather than later!
Paralysis of Analysis is Personal Malpractice
It is frankly silly to expose life insurance to death taxes where steps can easily be taken to make it tax-free. For that reason, if your advisors do not recommend use of a well-designed ILIT to you, they should be found guilty of malpractice. If you fail to avoid the taxes for your loved ones, you are the one guilty of malpractice as a parent or spouse, and frankly may be approaching inability to competently manage your own finances.
Call us for personal and specific answers in your case.