In most cases life insurance proceeds can pass to named beneficiaries of the policy free from personal income tax, but those proceeds are still subject to estate taxes. That’s right--the general rule is that life insurance proceeds are subject to federal estate tax (and, depending on your state’s laws, state estate tax as well).  

Ownership of the Insurance Policy is Key 

Generally, all the property you own at your death is subject to federal estate tax. However, each of us has a lifetime estate tax exemption ($11.4 million in 2019), so only individuals with estates that exceed this exemption amount need to be concerned about planning for estate tax. The important point here is that estate tax is imposed only on property in which you have an ownership interest; so if you don’t own your life insurance, the proceeds will generally avoid this tax. This begs the question: Who should own your life insurance instead? For many, the answer is an irrevocable life insurance trust, or ILIT (pronounced "eye-lit").  

What is an ILIT? 

An ILIT is a trust primarily set up to hold one or more life insurance policies. The main purpose of an ILIT is to avoid federal estate tax. If the trust is drafted and funded properly, your loved ones should receive all of your life insurance proceeds, undiminished by estate tax. 

How does an ILIT work? 

Because an ILIT is an irrevocable trust, it is considered a separate entity. If your life insurance policy is held by the ILIT, you don’t own the policy--the trust does. 

You name the ILIT as the beneficiary of your life insurance policy. (Your family will ultimately receive the proceeds because they will be the named beneficiaries of the ILIT.) This way, there is no danger that the proceeds will end up in your estate. This could happen, for example, if the named beneficiary of your policy was an individual who dies, and then you die before you have a chance to name another beneficiary. Since you don’t own the policy and your estate will not be the beneficiary of the proceeds, your life insurance will escape estate taxation. Your first step is to draft and execute an ILIT agreement. 

Seek Qualified Legal Counsel  

Precise drafting of the ILIT agreement is essential and you should hire an experienced attorney.