Avoiding a Tax Bomb on Proceeds from a Life Insurance Policy

Life insurance is a contract entered into between a policy holder and an insurance company. Specifically, the life insurance policy holder makes set payments to the insurance company in exchange for the promise that the company will pay a designated sum of money to a beneficiary in the event that the policy holder passes away. All Massachusetts residents are subject to a state estate tax if their estate is valued over $1 million.

Your estate includes all of the property you own, including tangible personal property (your “stuff”), intangible personal property (bank accounts, IRAs, 401Ks, business interests, etc), and real property as well as any proceeds from a life insurance policy. Because the proceeds on a life insurance policy can be in the hundreds of thousands and even millions of dollars, these proceeds exponentially raise the value of your estate and the tax bomb that your estate faces.

Is there a way to avoid the estate taxes due because of the proceeds received from a life insurance policy?

You can avoid the tax bomb on life insurance proceeds if you set up an irrevocable life insurance trust (ILIT). The ILIT takes the life insurance policy away from your estate and places it in a separate trust. The policy is therefore no longer owned by you. Rather, it is owned by the trust. Because it is irrevocable, you cannot change your mind and dispose of the trust. While this finality may seem alarming to many, the ILIT does allow you to control many other decisions related to the ILIT.

For instance, you can designate beneficiaries. You can also dictate terms for when and how they will receive the life insurance proceeds. Under the regular scheme, payout upon death is immediate and in full. Under an ILIT, you can stagger payments. You can also dictate what exactly the proceeds are to be used for, such as for living expenses or education. This helps younger children or adults with budgeting issues.

How do I set up an irrevocable life insurance trust?

To set up an ILIT, you simply need the names of your beneficiaries, the name of your trustee, and all of the terms you wish to set out for the distribution of the trust (how, when, and how much). Then obtain a life insurance policy, making the ILIT the owner and beneficiary of your policy. If you already have a policy, transfer ownership to the ILIT.

Setting up an irrevocable life insurance trust can be complex, and there are certain requirements that need to be met, but an experienced Massachusetts estate planning attorney can help you evaluate whether it is your best option. Contact The Sullivan Firm, P.C. today at (978) 325-2721 for a free consultation on trusts.

Troy Sullivan, Massachusetts Estate Planning AttorneyThe Sullivan Firm, P.C. is a boutique probate and estate planning law firm serving the North Shore and Cape Ann of Massachusetts including Gloucester, Rockport, Manchester and Beverly. The firm concentrates on estate planning matters, including trusts, wills, healthcare proxies, life planning, probate, special needs trusts, and trust administration.