DISCLAIMER: The purpose of this article is to provide general information which is subject to change and is specific to state law. The author and ReliaQuote are not providing legal advice. If you have a specific legal issue, you should consult a lawyer who is licensed to practice law in your jurisdiction.

Life insurance proceeds are tax-free, right? Unfortunately, that adage is only half true. While life insurance proceeds are income tax free to your beneficiary(ies), they are generally subject to estate taxes. This can be very problematic given the fact that one of the great benefits of life insurance is the liquidity and income replacement it provides a family subsequent to the loss of a loved one and that the level of coverage your premiums are purchasing may be reduced by as much as fifty percent (50%) by the federal estate tax, thereby depriving your loved ones of the very protection you intended to provide. For example, if a life insurance policy provides a death benefit of One Million Dollars ($1,000,000), but before those proceeds can be distributed to the beneficiaries, the estate tax bill associated with that policy must be paid, and the tax rate for that estate is forty percent (40%) (current estate tax rates range from thirty-seven percent (37%) to fifty percent (50%)), the death benefit that will reach the beneficiaries is only Six Hundred Thousand Dollars ($600,000). The result is that the protection you intended to provide for your beneficiaries does not amount to the protection they actually receive. Why does this happen and, more importantly, what you can do to avoid making this mistake?

The IRS states that any life insurance policies over which you have “incidents of ownership” (i.e. the right to change the beneficiary and to make other decisions with respect to the policy) will be included in your estate for estate tax purposes. Essentially, any life insurance policies you own will be included in your estate and will be subject to estate taxes upon your death. The question is this: Is it possible to ensure the right people receive the proceeds upon your death but avoid including those proceeds in your estate by changing the owner of the policy? The answer is yes!

The solution is to make sure that, while the life insurance proceeds will be distributed to the proper individuals, but that you do not retain the ownership rights associated with those life insurance policies which would cause the inclusion of those policies in your taxable estate and therefore would result in a dilution of the protection following the payment of estate taxes. This is accomplished through the use of an Irrevocable Life Insurance Trust (ILIT). You create an ILIT and name someone you trust as the Trustee (i.e. spouse, sibling, etc.). After the ILIT is created, you make the trust the beneficiary of the policy and you assign the ownership of the policy to the trustee. The ILIT will receive the proceeds upon your death and will hold those proceeds for the beneficiaries of the trust (which you chose when you created the trust). For example, your ILIT can provide that your surviving spouse will benefit from the proceeds during his/her life and upon his/her death, the remaining proceeds will be distributed to your children, as you intended when you named your spouse as the primary beneficiary and your children as the secondary beneficiaries.

This plan works because after you assign the ownership of the policy(ies) to the ILIT, you no longer have any ownership rights with respect to the policy(ies) and, therefore they will not be subject to estate taxes upon your death. The IRS allows for this planning, but requires that the assignment of the ownership of the policy(ies) take place at least three (3) years prior to your death for the transfer of the ownership to take effect. Consequently, this planning should be implemented as soon as possible so the “three year rule” will be satisfied.

The purposes of your life insurance coverage are no different, but the estate tax results could not be more different. Because the ILIT owns the policy, it will not be included in your estate and will not be subject to estate tax on your death. Consequently, the value of the policy is passed to your beneficiaries undiluted by the estate tax. Let’s revisit the example from above: Without the planning, a One Million Dollar ($1,000,000) policy subject to a forty percent (40%) estate tax results in a realized benefit of Six Hundred Thousand Dollars ($600,000) to your beneficiaries. If an ILIT is used correctly, that same One Million Dollar ($1,000,000) policy will not be subject to estate taxes and the realized benefit to your beneficiaries will be the full One Million Dollars ($1,000,000). In a very real sense, this planning can and will save your loved ones hundreds of thousands of dollars.

Is an ILIT right for you? See an estate-planning attorney to find out.

This article was written by C. Daniel Vaughan, Esq. C. Daniel (Dan) Vaughan is an estate planning attorney with the law firm of Vaughan, Fincher & Sotelo PC in McLean, Virginia. He is licensed to practice law in Virginia and other members of his group are licensed to practice in Virginia, Maryland and the District of Columbia. The group is focused on developing and administering comprehensive estate plans tailored to individual needs and circumstances. Dan can be reached at (703) 506-1810 or by e-mail at dvaughan@vfspc.com.