Life insurance can play an important role in your estate plans. Life insurance proceeds are normally free of income tax, although they are subject to estate tax. An irrevocable life insurance trust can reduce your estate tax bill, but you should exercise care in selecting the type of policies to use in an ILIT. An ILIT might allow you to maximize the value of other inherited assets.
Term insurance is temporary -- it terminates after a set period. Term insurance is the least expensive type of insurance. It typically offers a death benefit, but little else. Some term policies return part of the premiums to insured individuals who outlive the insurance. Whole life and other types of policies build up a cash value through higher premiums and possibly through investments, which are tax-deferred as long as they remain with the policy. You can borrow against the cash value of these policies tax-free, though you must pay interest to your policy.
Irrevocable Life Insurance Trust
An ILIT is a type of trust specifically designed to hold insurance policies. By donating a policy to an ILIT, you remove the insurance proceeds from your estate. You must also donate the premiums for the policy, which further reduces your estate. Some ILITs house second-to-die policies, which normally are used to insure married couples and pay out only after the death of both individuals. These policies typically have smaller premiums and are useful when the surviving spouse does not need the insurance proceeds.
While you can use any term policy -- either individual or group -- to fund an ILIT, you may outlive it and render the ILIT useless. If you use a whole life policy and continue to pay the premiums, you are assured that the policy will be in place at your death. If you rely on a term policy that expires, your heirs might have to liquidate your estate to pay the taxes that the ILIT would have paid had you used a whole life policy. If you do use a term policy for an ILIT, you might want to use a policy that guarantees you the right to convert it to whole life.
ILITs and IRAs
You can use an ILIT to maximize the utility of an individual retirement account to your spouse. When you reach age 70 1/2, you must begin taking required minimum distributions from a traditional IRA. If you use these distributions to pay the ILIT policy premiums, you remove the distributions from your estate. You can arrange with your spouse to convert your traditional IRA to a Roth IRA at your death and use the ILIT proceeds to pay the taxes on the conversion. In this way, you don’t have to pay the conversion taxes during your lifetime, and your spouse can distribute your IRA assets tax-free, thereby maximizing their value.