What is it? Why use it? How can it save taxes?
INDEX TO THIS PAGE
- Federal Estate Tax Savings
- How Is The Trust Used?
- Pennsylvania Inheritance Tax Savings
- What Is An Irrevocable Life Insurance Trust
An Irrevocable Life Insurance Trust is a completely legal device that can be used to keep the proceeds from a life insurance policy out of your estate for Federal Estate Tax purposes. It can also keep those proceeds out of the estate of your surviving spouse for both Federal Estate Tax purposes and for Pennsylvania Inheritance Tax purposes. It enables you to give your children and other heirs more of what you intended them to receive at the time of your death and to avoid having to pay taxes on that money.
At the time of your death, your estate - everything of value that you own - is often subject to two different taxes: (1) Federal Estate Tax and (2) Pennsylvania Inheritance Tax. It may also be subject to other taxes but for the sake of simplicity, we will only discuss those two taxes. An Irrevocable Life Insurance Trust has the potential to save both of these taxes.
Federal Estate Tax Savings
If your estate is the named beneficiary of a life insurance policy on your life or if you are the owner of that policy (or have other incidents of ownership - for example, the right to borrow against the policy or the right to designate who will be the beneficiary) the proceeds from that policy will be included in your estate for Federal Estate Tax purposes. (*) This means that when the Federal Estate Tax is computed, the amount of money that the insurance company paid out will be included in the total amount on which the tax is based. For example, if you are in the 40% tax bracket and you own a $500,000 policy on your life, your Federal Estate Tax will be increased by $200,000 (This figure is approximate - the increased size of the estate may also increase the available credits, making the actual tax increase slightly smaller.).
If the insurance policy is owned by your Irrevocable Life Insurance Trust instead of by you and if the proceeds are payable to the trust rather than to your estate and if the documents were properly prepared and if you followed proper legal advice about administering the trust during your lifetime, upon your death, the proceeds of the policy will not be subject to any Federal Estate Tax. If the documents were not properly prepared or if proper procedures were not followed, the proceeds may still be subject to tax.
Pennsylvania Inheritance Tax Savings
Life insurance proceeds are generally exempt from Pennsylvania Inheritance Tax. Thus, even if you own a policy on your own life or if the policy is payable to your estate, there will be no Pennsylvania Inheritance Tax on the policy proceeds at the time of your death. However, if the proceeds are paid to your surviving spouse, later - when your spouse dies, the money from the policy is no longer "life insurance" - it's just money. If the proceeds were invested in something else - for example, a mutual fund - it's no longer "life insurance" - it's a mutual fund. The money or the mutual fund or whatever else the money was invested in will be subject to Pennsylvania Inheritance Tax - it is no longer exempt. (**) However, if the life insurance had been owned by an Irrevocable Life Insurance Trust, it would not have been subject to Pennsylvania Inheritance Tax upon the death of either spouse. Therefore, even if your estate is not large enough to be subject to any Federal Estate Tax (*), an Irrevocable Life Insurance Trust is one of the devices that can be used to save Pennsylvania Inheritance Tax when your spouse dies.
What Is An Irrevocable Life Insurance Trust
An Irrevocable Life Insurance Trust, like any trust, is simply a legal arrangement between two people - the "Settlor" and the "Trustee" - for the benefit of someone else - the "Beneficiary." The Settlor sets up the trust and the Trustee administers the trust for the benefit of one or more other people - the Beneficiaries. In the case of an Irrevocable Life Insurance Trust, the Trustee owns one or more policies of life insurance on the life of the Settlor. The Settlor makes at least one gift to the trust - either one or more life insurance policies or cash. It is generally better to make a cash gift and have the Trustee purchase the life insurance policy on the Settlor's life. If the Settlor transfers a policy to the trust, the proceeds will still be taxed in the Settlor's estate if the Settlor dies within three years of the date of the transfer. If the Settlor transfers cash and the Trustee buys the policy, generally the proceeds will not be taxable no matter how soon the Settlor dies. Depending upon the type of policy, and the other assets in the trust, the Settlor may have to make annual cash gifts to the trust to enable the Trustee to pay the annual policy premiums. Special procedures must be very strictly followed each time the Settlor transfers something to the trust or else the Settlor may owe Federal Gift Tax on the transfers to the trust. Details on the procedures to be followed and the negative consequences that can result from the failure to follow those procedures are beyond the scope of this brief article.
How Is The Trust Used?
Upon the Settlor's death, the insurance proceeds can be used for the beneficiaries of the trust - the Settlor's spouse, his or her children or other persons that the Settlor wanted to benefit. The proceeds may also be made available to replace other assets in the Settlor's estate that had to be used to pay taxes. The use of the trust is a method of creating funds to indirectly pay those taxes without increasing the size of the estate subject to the tax. If the Settlor had merely purchased more life insurance is his or her own name to help pay Federal Estate Tax, the size of the estate - and thus the amount of those taxes -would have been increased. By using the Irrevocable Life Insurance Trust to purchase and own the life insurance policy - the funds are available to pay the taxes but the amount of the taxes themselves has not been increased.
The Irrevocable Life Insurance Trust also can be used to "leverage" gifts to benefit the Settlor's children or other heirs. By making small gifts to the trust - the amount of cash necessary to pay the policy premiums - the Settlor can bestow large benefits - the proceeds from the policy - on the Settlor's children without having to pay Federal Estate Tax (and if structured properly) without having to pay Federal Gift Tax on the gifts to the trust. (***)
The Irrevocable Life Insurance Trust - like any trust - also provides a method of protecting the beneficiaries from their own immaturity or imprudent conduct or the claims of their creditors.
Copyright 2014 Marc H. Jaffe
(*) See the article at this Website concerning Federal Estate Tax Threshold
(**) See the article at this Website concerning Pennsylvania Inheritance Tax Rates
(***) See article at this Website concerning Gifts and Federal Gift Tax
Warning: This document is for informational purposes only - it is not legal advice. The requirements for obtaining favorable tax treatment can be very complicated and must be strictly followed. You should consult with an attorney in the state where you reside to determine how your own taxes should be calculated and what tax saving may be available to you from the use of an Irrevocable Life Insurance Trust before acting on the information contained here.