Since we are in the middle of tax season I have tried to keep this week's topics around insurance and taxes. The last one is a bit different but may be of use to some people.
As the title of this post implies, we are going to take a quick look at trusts and why people use them for life insurance purposes. And like my previous posts, I am obligated to give my disclaimer that I am not a tax expert, so if you have more specific questions about the tax implications I recommend consulting a tax professional.
Why would anyone want to put life insurance inside of a trust, you ask? For several reasons, actually. For instance, there are those people who have special needs children and may be interested in funding their care as they become special needs adults. In that instance, we use a Special Needs Trust and a "second to die" life insurance policy to fund it when both parents pass away.
However, for the purposes of this blog we will look at Irrevocable Life Insurance Trust (ILIT). When we (or our attorney) create a trust, it's basically like creating a whole new entity, like a new person. The purpose of using the trust for life insurance is for estate tax purposes. The life insurance policy inside the trust is no longer part of the estate, so it can't be taxed.
The current federal estate tax exemption is $11,700,000, which is very high and adjusted for inflation each year. However, the amount is scheduled to drop to $5,000,000 on December 31, 2025. And now that the Democrats are in control of congress it may drop sooner.
I realize that for many people these numbers may seem extremely high. At the same time, I know a business owner who purchased a piece of land many years ago and opened a small restaurant. The value of that property increased dramatically over years since he bought it, so his house and business are close to reaching that $5m threshold. When I discussed it with him, he was totally unaware.
Another thing to consider is that you can name a trustee, who may be a family member but can also be a friend or even your attorney. This trustee can use the policy proceeds (death benefit) for your beneficiaries without giving them full control of the monies. This is important if you have small children, a second marriage or if your beneficiaries can't manage the money on their own.
My advice when it comes to these kinds of situations is to consult a good estate attorney who has experience in these matters. Just because an attorney can make a will does not necessarily mean they understand trusts. When the word "irrevocable" is in the name it means you can't change things later. As a good attorney friend of mine once said to me, "Get a lawyer who has done this before. You don't want one to practice on your client."
There are a few rules you need to be aware of. Some are:
- You can transfer existing policies into the trust but there is a three year lookback, so if you die in the first three years the death proceeds will be included in your estate and potentially taxed.
- The estate is a separate entity and will need it's own tax identification number. Because of this, your premiums will need to be "gifted" to the trust. The trust will, in turn, pay the premiums to the insurance company.
Chris Castanes is the president of Surf Financial Brokers, helping people find affordable life and disability insurance coverage. He's also is a professional speaker helping sales people be more productive and efficient and has spoken to professional and civic organizations throughout the Southeast. And please subscribe to this blog!