After recent tax legislation, including the Tax Cuts and Jobs Act (TCJA), very few tax shelters are left standing. One key exception is life insurance. If certain requirements are met, the buildup of value in a life insurance policy is exempt from current income tax, while proceeds payable upon death can avoid estate tax.
But there’s a potential problem if you possess any “incidents of ownership” in the life insurance policy. In that case, the proceeds are included in your taxable estate. Yet there’s a simple solution: transfer the policy to an irrevocable life insurance trust (ILIT).
Naturally, you forfeit the estate tax exemption if you own a policy outright, but the rule goes much further than that. Typically, it applies if you reserve certain policy rights, such as the right to change beneficiaries or borrow against the policy. Depending on the circumstances, if you retain incidents of ownership in a policy with a payoff in six figures, it could trigger estate tax when you die.
Fortunately, you can avoid this result by establishing an ILIT and transferring ownership of the policy, including all the other rights, to the trust. The transfer may be sheltered from gift tax by the $11.18 million gift and estate tax exemption under the TCJA. Designate someone you trust — such as a professional or family member — to act as the trustee. If you require additional life insurance coverage, arrange for the ILIT to acquire any new policies.
Remember that the life insurance trust must be “irrevocable” to qualify for the estate tax break. So you can’t change your mind once you make the commitment.