Overview
Irrevocable Life Insurance Trusts (ILIT)
Using Ownership and Beneficiary Designations
How to Get Existing Policies Out of My Estate
Can the Three-Year Rule be Avoided?

Overview

For large estates, it is generally advisable to keep life insurance proceeds out of your taxable estates (and if married, your spouse's). A common life insurance mistake made by affluent people is to leave their spouses as owners or beneficiaries of life insurance. This error can increase the gross estate and ultimately increase the amount of estate taxes due.

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If your estate is large enough (over $1.2 million in a properly planned estate), there will be estate taxes payable after you and your spouse die. Consider keeping your insurance proceeds out of your estate as long as your spouse does not need the insurance proceeds to survive after your death. However, if your spouse needs money to provide for family income or needs, then it is wise to make your spouse the beneficiary of your life insurance. Having spouses be the owner of each other's policies (cross ownership) is unnecessary.

Irrevocable Life Insurance Trusts (ILIT)

An Irrevocable Life Insurance Trust (ILIT) is often used to keep life insurance out of your taxable estate. Generally, money is gifted to the trust. The trust then applies for life insurance on the insured, or insured's in the case of Second to Die life insurance. The trust is the owner and beneficiary of the life insurance policy. Usually the children/grandchildren are beneficiaries of the trust. There are technical details that must be written correctly to make sure that the insurance proceeds are not part of the taxable estate. A qualified attorney should be consulted to draft the ILIT and to make sure that the technical details are handled correctly. Recent court cases have shown the ILIT is not the only way to keep life insurance out of the estate.

Using Ownership and Beneficiary Designations

If certain rules are adhered to, it is possible to name a child as owner and beneficiary of a new life insurance policy in a way that will keep the insurance proceeds out of your taxable estate. Generally, premiums must be gifted to the children and the children must pay the premiums. It is extremely important the insured person avoids all incidence of ownership when using this strategy.

Extreme care must be taken if the child is still a minor, or if more than one owner and beneficiary will be named on the same policy. In these types of situations, competent insurance advice is critical. Other advisers on your estate planning team, including your CPA (for gift tax ramifications) and attorney, should also be consulted.

How to Get Existing Policies Out of my Estate

Existing life insurance policies can be transferred out of your taxable estate. This is generally accomplished in one of two ways. One way is to name an Irrevocable Life Insurance Trust as the owner and beneficiary of the policy. Another way is to name a child or grandchild as owner and beneficiary. In either instance, the insured must live for three years after the transfer, or the insurance proceeds will be considered part of the taxable estate. It is important to note that any transfer to a third party will constitute a gift equal to the current policy surrender value. A CPA should be consulted to make sure that any required gift tax returns are filed to document this gift.

Can the Three-Year Rule be Avoided?

With proper planning the three year rule can sometimes be avoided. Consider a 65 year old male who purchased several large life insurance policies to protect his family while the children were growing up. The family has now grown up and money needs to be made available to pay estate taxes. The insured and his wife may decide to buy survivorship life insurance to pay estate taxes economically. The parents set up an ILIT which in turn buys a NEW life insurance policy (a Second to Die life insurance contract). This new policy is not subject to the three year rule. The existing life insurance policy on the father can be surrendered. If a large taxable gain exists, they may want consider a 1035 exchange to a Deferred or Immediate annuity. Either option would defer the gain on the existing life insurance and help generate income to offset the cost of the survivorship policy.

Assume the father is a widower in the above example and Second to Die life insurance is inappropriate. If his current life insurance policy(s) are very old and performing poorly, he may want to consider purchasing a new, more competitive policy. In this situation, he could have an ILIT set up and have it purchase a new and better performing life insurance contract (please note the section on replacement). This new insurance policy would instantly be out of the estate! The old contract could be surrendered and 1035 exchanges could be considered if there was a taxable gain.