Estates in Maryland and D.C., and many other states, face estate tax if the net amount of the estate, excluding spousal transfers and charitable gifts, exceeds $1 million. The value of the estate includes the proceeds of life insurance. Many families, especially families with young children, face state and/or federal estate taxes because they own life insurance. One common solution for avoiding these taxes is to implement an irrevocable life insurance trust.

An irrevocable life insurance trust (usually called an “ILIT”) is a special type of trust that takes ownership of your life insurance policy. Because the trust — and not you — owns the policy, the proceeds are not taxed to your estate upon your death. Creating and maintaining an ILIT costs money. It also imposes certain restrictions. Most significantly, the trust owns your life insurance policy, not you. Therefore, for example, you can never change beneficiary designations. Therefore, an ILIT is not the right solution for everyone.

Many people with life insurance recognize that they are unlikely to die, so that they need not worry about the tax on their estate. And even if the owner of the life insurance policy does die, it is quite likely that his or her spouse will not die at the same time. Under those circumstances, the ILIT may be unnecessary, because if the spouse is the beneficiary and survives the insured, then there is no tax because inter-spousal transfers are tax-free.

However, we buy insurance to insure against risk. We decide to insure against risk based on the assessment that the cost of the insurance premiums is outweighed by the benefits of the policy should the unlikely event occur. Using that same thinking, many people choose to use ILITs because they believe that the cost of creating and maintaining the ILIT is far less than the tax that their estate would face.

A simple cost benefit-analysis shows the value the ILIT can provide. Assume that it costs $2,500 to create an ILIT and $600 per year to maintain it. (In fact, in most cases the startup and annual costs are significantly lower than that.) If someone invests that money instead of creating an ILIT, with the aim of using the invested money to pay the ultimate tax burden on the proceeds of the policy, then she will have about $31,000 (presuming a 6% return) after 20 years. The taxes on an estate of $1.55 million in the District of Columbia, based on current tax rates, would consume all of that amount plus about another $35,000. And if the Client dies after only ten years, then she has saved about $12,750 — falling far short of her likely $67,600 tax bill.

Thus, for the taxpayer whose life insurance puts them over the $1 million tax-exempt amount by about $500,000, the tax savings of the ILIT far outweigh the costs of creating it. Despite that, some people are comfortable paying the tax from the proceeds of the life insurance policy because they conclude that it will not harm their heirs’ finances. On the other hand, others choose to create the ILIT because the cost benefit analysis makes it clear that it is a better choice financially. This is especially true for those families who cannot or will not shelter the proceeds through a spousal transfer or for those families for whom the amount of estate taxes will be greater than the example we are using here.

If you are considering preparing an ILIT and you are purchasing a new life insurance policy, we strongly encourage you to hold off finalizing the purchase. We would ask the insurance company to change the name of the owner and beneficiary of the policy to reflect the name of the trustee of the life insurance trust. If you prepare an ILIT after you buy the policy, the ILIT can buy the policy from you, but it adds another bit of complication and, more importantly, it means that the tax-exclusion effect of the ILIT does not exist for three years from the date of the purchase.

Please remember that this discussion is not meant to substitute for a careful analysis of your situation. Every case is different, and the solutions for every estate are different. We encourage you to seek advice from a qualified attorney before taking any action.