If you own a life insurance policy that has built up a sizable cash value, be aware that the death benefit will be included in your taxable estate. Although life insurance payouts are generally income tax-free, they are not free from the burden of estate tax. Depending on the size of the policy and the applicable estate tax exemption when you die, the tax bill could be substantial. What can you do to minimize tax liability?
Transferring the policy to an irrevocable life insurance trust (ILIT) is one option. The death benefit will be paid to the ILIT and distributed to the trust’s beneficiaries, bypassing your taxable estate. The downside is that the transfer is considered a taxable gift, based on the policy’s cash value. But this generally will be significantly lower than what the death benefit’s value would be for estate tax purposes. In fact, a U.S. Gift Tax Return will in all likelihood have to be filed to report the gift.
Don’t overlook the “three-year rule,” though. This rule provides that, when you transfer a life insurance policy to an ILIT, the death benefit will be “pulled back” into your estate if you die within three years — all the more reason to transfer a policy sooner rather than later.
An alternative strategy
Alternatively, if you’re currently in good health, consider using your existing policy’s cash value to fund a replacement policy that can be purchased and held by an ILIT. This strategy may be cheaper and less risky from a gift and estate tax perspective, but tapping your policy’s cash value may have significant income tax implications.
Whether you transfer an existing policy to an ILIT or you establish an ILIT to purchase a new policy, you can make gifts to the ILIT to cover the premiums and other expenses. Depending on how you set up the trust, you may be able to apply your $14,000 annual exclusion to the gifts. Contact us if you’d like to learn more about using an ILIT.