One common way to get around estate taxes on your life insurance is to create an irrevocable life insurance trust. You transfer the ownership of your life insurance policy to the trust, effectively taking advantage of a loophole to get around estate taxes.
Beware of the life insurance tax trap! Various forms of life insurance are likely to be an important part of your estate planning, from protecting your estate to creating cash that goes to one or more of your beneficiaries.
However, the tax laws dictate that the death benefit from your life insurance policy gets added into the rest of your estate when calculating your estate’s value and the amount of estate tax you owe. As a result, you must look ahead to various tips and tricks to help get around this tax trap!
If you think an irrevocable life insurance trust makes sense in your situation, you need to be aware of the following:
As the name implies, your life insurance trust must be irrevocable, otherwise goodbye, estate tax break! With a revocable trust, you can change your mind about the trust, or the property in the trust (or whatever is left over) transfers back to you. In order to qualify for the estate tax break, the trust has to be irrevocable. After the trust owns the life insurance policy, you can never get it back or make any changes!
You can’t be the trustee of an irrevocable life insurance trust that contains your own life insurance policy, even though you don’t own the policy (the trust does).
You need to act now! The IRS also says that if you set up an irrevocable life insurance trust but die within three years of the transfer of the life insurance policy, then the IRS acts as if the trust never existed and you still owned and controlled the policy. And then, you lose the estate tax break.
Another estate tax saving strategy for your life insurance policy, instead of an irrevocable life insurance trust, is to transfer ownership of the policy to someone else. The secret recipe is for the IRS to agree that you didn’t own and control the policy, which means you get an estate tax break! But note that the same three-year period for the gift inclusion will apply.
If you don’t own and control your life insurance policy because it’s owned by an irrevocable life insurance trust, how can you pay your premiums to keep the policy in effect? You can, of course, have someone else pay the premiums for you — your spouse or the beneficiary of the policy, for example. Or you can set up a Crummey trust to take care of the payments.
Crummey trusts are very complicated and best explained by your estate planning attorney doing a John Madden drawing of a football play, showing how money transfers back and forth, how the gift tax annual exclusion applies, and all kinds of pretty complicated rules and restrictions. But if you and your estate planning team decide that an irrevocable life insurance trust makes sense for you and your beneficiaries, ask whether a Crummey trust makes sense, too.