The irrevocable life insurance trust (“ILIT”) provides an accessible means of avoiding New Jersey and federal estate taxes on life insurance proceeds. The potential savings often outweigh the disadvantages of what you give up.
The New Jersey and federal “estate taxes” are taxes on the transfer of property at your death. Life insurance proceeds are among the types of property that are subject to estate tax. The taxable status of life insurance proceeds is determined by ownership of the policy and payment of the proceeds. If you own a life insurance policy, upon death, your estate will be fully subject to tax if: (1) The proceeds of the policy are payable directly or indirectly to your estate; or (2) if you, while alive, held any ownership rights in the policy, such as the right to change a beneficiary, surrender or cancel the policy or borrow against the policy.
If you leave life insurance proceeds to someone other than a spouse, such as a child, relative, or friend, the proceeds will be taxed as being part of your estate. On the other hand, if you leave life insurance proceeds to a spouse, the proceeds will not be part of your estate at your death, but the surviving spouse’s estate may be taxed. An ILIT can avoid taxes not just on your own estate, but also on the estate of your surviving spouse.
The ILIT itself would own the life insurance policy and is named as its beneficiary. Each year, you gift an amount sufficient to pay the policy premiums to the trust. Then, the trust pays the premiums. You can gift up to $13,000 per year to the trust, per beneficiary named in the trust, without incurring any gift tax liability. Upon your death, the insurance proceeds are paid into the trust. The ILIT is drafted to ensure that the insurance proceeds will not be taxed as part of your estate; however, the beneficiaries of the trust will be able to access the monies held by the trust for health, education, maintenance and support. Typically, the trust is drafted so that the surviving spouse also has a right to receive the income from the trust and perhaps even a limited right to invade principle. This will also protect the monies held in the trust from creditors of the beneficiaries, or in the event a beneficiary becomes divorced. On the death of the surviving spouse, the monies held in trust can either be paid outright to your children, or the trust can continue.