Money in a LockboxPeople usually purchase life insurance policies with the intention of providing for their loved ones after they die. Depending on the overall size of your estate, however, your loved ones may not receive all the death benefits. As of 2012, if your entire estate is worth more than $5.12 million, any value over that amount is subject to federal estate tax at the rate of 35 percent. You can avoid estate taxes on your insurance proceeds by creating an irrevocable life insurance trust.

Your Trust Must Own the Policy

If you own your life insurance policy, the Internal Revenue Service (IRS) considers it part of your estate for estate tax purposes. It contributes to your estate's value. However, if you create an irrevocable life insurance trust, the trust can purchase the policy instead. To avoid estate taxes, your trust must also be the beneficiary of the policy.

You Must Give Up Control

If your trust purchases and owns your policy, you have no control over it, and this is an IRS requirement for avoiding estate taxes on the proceeds. You have no right to change the beneficiary or borrow from the policy or against it, although you can name its beneficiary when you form the trust and instruct the trustee to purchase the policy. Because your trust is irrevocable, you would typically not serve as trustee, which eliminates any appearance that you control the policy.

Who Pays the Premiums?

Even though your trust owns the policy, you can still pay the premiums. You can transfer cash to the trust on a regular basis, and the trust can use this money to pay for the policy. However, there's one small catch. As of 2012, you can only make gifts of $13,000 each year to any one person or entity. If you give more than $13,000, you'll incur a gift tax on the balance. If the money you give the trust to pay for your policy is less than $13,000 each year, there are no tax implications.

Transferring Can Be Risky

If you already own a life insurance policy and you want to take advantage of an irrevocable life insurance trust to shield the proceeds from estate taxes, you can transfer ownership of the policy to the trust. If you die within three years of the transfer, however, the IRS will pull the proceeds back into your estate. They'd be subject to tax if the proceeds increase the value of your estate to more than $5.12 million.

Your Beneficiaries Still Inherit

When your trust receives the death benefits from your policy at your death, it can transfer the funds to your beneficiaries just as if you had named them directly in the policy. The only difference is that the proceeds fall outside your estate, so your beneficiaries will not have to share any portion of the proceeds with the IRS.

An Estate Attorney Can Help

The law surrounding irrevocable life insurance trusts is complicated. Plus, the facts of each case are unique. This article provides a brief, general introduction to the topic. For more detailed, specific information, please contact an estate attorney.

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