Most people believe that life insurance proceeds are not taxable. This is true and not true at the same time. Life insurance proceeds that are received by a beneficiary in a lump sum are not subject to income taxes. However, if the proceeds are not received all at once there will be an income component that wil be taxable.
Life insurance proceeds are included in the owners gross estate for the determination of estate taxes if they owned or had an incidence of ownership at the time of their death. Starting next year this could mean that proceeds from life insurance could be taxed by as much as 55 percent. However, there is a fix to this situation. The ownership of the policy must be bifurcated. This means that the insured cannot own the policy.
How do we take the ownership of the policy away from the insured? We create an irrevocable life insurance trust that becomes the owner of the policy. Thus, the insured is no longer the owner of the policy and the proceeds from the policy are not included in the estate of the insured.
How are the premimums paid? The insured gifts enough money to the trust each year to pay the premiums. The insured uses their annual gift exclusion amount to make these gifts non-taxable for gift tax purposes.
An irrevocable life Insurance Trust (ILIT) can be a very powerful tool for estates that have life insurance and will be taxable in the coming years.