Many people automatically assume that the life insurance death benefit they leave over to their loved ones will not be taxed. This common misconception can result in the unnecessary payment of tens or hundreds of thousands of dollars of estate taxes.

The Rule: The IRS (Section 2042) states that the death benefit of your life insurance policy is included in your estate if the proceeds are payable either (1) to your estate or (2) to your beneficiaries if you possessed any incidents of ownership in the policy at the time of your death. Incidents of ownership include the right to (1)change/add beneficiaries (2) transfer ownership of the policy (3) borrow against the policy, among other rights.

The Problem: With the New York estate tax set at $1,000,000 and the federal estate tax set to return to $1,000,000 in 2013, many New Yorkers who own their own home, have some savings, and own a life insurance policy will be subject to estate taxes. For example, a New York resident who passes away in 2013 with a taxable estate and a $500,000 life insurance policy with pay $350,000 in estate taxes.

The Solution: There is an effective and legal way to avoid this unnecessary scenario. Instead of having you own the life insurance policy in your own name, an estate planning attorney can set up an irrevocable life insurance trust (ILIT) to own the policy with the proceeds going into the trust. If you don’t own the policy, you don’t have “incidents of ownership" according to the IRS and consequently your estate is not taxed on the proceeds of the death benefit.

The Practicalities: An irrevocable life insurance trust is just that, irrevocable. This means that the trust can not generally be undone and the terms can not be altered by you. You may set the terms of the trust, decide who the beneficiaries will be, and appoint any trustee you desire, including a spouse and/or children. The trust may specify who gets the money and under which circumstances. This provides potential asset protection for your beneficiaries and can protect them from creditors, ex spouses, and their own immaturity when it comes to spending the money. The trust can accept an existing life insurance policy or can purchase a new one. If an existing policy is transferred, the IRS will wait three years before it will be considered owned by the trust. If you pass away before that time, the proceeds will be counted in your gross estate. This is why it is highly recommended that an ILIT is set up contemporaneously with the purchase of any significant life insurance policy. Premiums will be paid by the trust with funds which you may want to gift to the trust. You can utilize your annual gift tax exemption amount of up to $13,000 which can be doubled to $26,000 for spouses. Upon your eventual passing, the insurance policy will pay out to the ILIT which will in turn distribute the funds as per your original instructions. All of this will be overseen by the trustee(s) which you selected. Best of all, none of the proceeds will be taxed by the government.

The Bottom Line: The whole idea behind life insurance is to provide the financial resources your loved ones need when you pass away. With the use of an irrevocable life insurance trust you can make sure that your loved ones get the maximum amount possible without Uncle Sam dipping his hands into the pot.