Estates in Maryland and D.C., and many other states, face estate taxes levied by the state when the net amount of the estate, excluding spousal transfers and charitable gifts, exceeds $1,000,000. The value of the estate includes the proceeds of life insurance. Many families face estate tax 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 (when thinking about the years during which the policy is in effect, of course), so that they need not worry about the tax on their estate caused by the life insurance. And even if the insured 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. The tax when the surviving spouse dies may be very burdensome, but the surviving spouse may consume or be able to give away the funds, thereby avoiding taxation at the time of his or her own death.
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 $1,750 to create an ILIT and $300 per year to maintain it. 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 nearly $30,000 (presuming a 6% return) after 20 years. The taxes on an estate of $1.55MM 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 $1,000,000 tax-exempt amount by about $500,000, the tax savings of the ILIT far outweigh the costs of creating it.
Despite the tax savings achievable through the ILIT, some people are comfortable paying the tax from the proceeds of the life insurance policy because it will not meaningfully harm their heirs’ finances. Others choose to pay 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 the name of the trustee of your ILIT.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.