Using Life Insurance Trusts to Reduce Estate Taxes

Part 1: Understanding the Problem

When planning for what happens to our assets after we pass away, many of us worry about how our family will manage expenses like funeral costs, debts, and taxes. Sometimes, the things we own, like a family business or certain investments, are not easy to turn into cash. Life insurance can help cover these costs, but there’s a catch. If the insurance policy is owned by the person who passed away or given directly to their spouse, it could increase the total amount that’s taxed by the government and trigger the imposition of the federal estate tax. In 2023 that may not represent a serious concern for many taxpayers, since the federal estate tax threshold for married couples is almost $26 million (half that number for individuals). But when the present Tax Cuts and Jobs Act expires at the end of 2025, the estate tax threshold reverts to $14 million for married couples in 2026, reducing the limit by almost half. The current 40% maximum gift and estate tax rate will also increase to 45% in 2026, the highest estate tax rate since 2009.

Addressing the Problem with an Irrevocable Life Insurance Trust (ILIT)

What’s an ILIT?

An ILIT is a special kind of trust meant to hold life insurance. It’s called “irrevocable” because once it’s set up, it can’t be changed or canceled. In an ILIT, someone (the insured) creates a trust and names a trustee (someone responsible for managing the trust) who, as trustee of the ILIT, owns the insurance policy. When the insured person passes away, the money from the insurance policy goes into the trust instead of their estate. This keeps the insurance money from being taxed along with the rest of the person’s assets, reducing the overall taxable estate.

Why is the ILIT Useful?

Avoiding Estate Tax: If the insurance policy is put into an ILIT and the person lives for at least three years after setting it up, the money from the policy doesn’t get added to their estate for tax purposes. This means more money can go to their family without being taxed.

Providing Immediate Money: ILITs can provide money right away to cover expenses after someone passes away, such as education for kids or supporting the family.

Protecting Assets: The ILIT can protect assets from creditors, meaning that the money in the trust is safe and can’t be taken to pay off debts.

Flexible Options: ILITs can have special rules, allowing beneficiaries to use the money wisely, like buying a house or supporting a charity.

Important Points to Note:

Trust Details: The ILIT’s rules need to be very clear, specifying who can get the money and for what purposes.

Tax Considerations: There are tax rules to follow, especially regarding when and how the trust can be funded, and who the beneficiaries are.

Avoiding Mistakes: Certain mistakes, like listing the estate’s representative as the beneficiary, can lead to tax problems, so it’s important to set up the ILIT correctly.

In essence, an ILIT is a smart way for people to make sure their life insurance money goes where they want it to go after they pass away, without being heavily taxed. It provides financial security for their loved ones and ensures their hard-earned money isn’t wasted on unnecessary taxes.

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