In Massachusetts, if you have life insurance, consider an ILIT.

An ILIT is an Irrevocable Life Insurance Trust. Used properly, it makes life insurance benefits free from estate tax. Here is why you should consider one if you live in Massachusetts and have life insurance.

Note: This article is provided for background information and education only; it is not legal advice. Don’t try this at home. An ILIT is a complex instrument and errors can lead to expensive problems, so consult a lawyer. This article contains information specific to Massachusetts that is not applicable in other states.

An ILIT is a trust that is designed to remove life insurance from a taxable estate, to save your heirs from paying estate tax on life insurance proceeds. This is a valuable tool that can save quite a bit of money down the road in exchange for a minimal amount of work.

You may have heard that life insurance proceeds are not taxable. This is not entirely correct. A beneficiary of life insurance proceeds does not pay income tax on the proceeds – but the proceeds are included in the estate for estate tax purposes, and an estate tax will be charged on them if the value of the estate – including life insurance proceeds – is more than the tax exemption. As of 2016, the federal estate tax exemption is $5.45 million, meaning that only a small percentage of estates pay the tax. But Massachusetts has its own estate tax. The Massachusetts exemption is only $1 million, and if an estate’s value is over that amount, the entire estate is subject to a tax. So if your estate is worth exactly $1,000,000, you’re in the clear – but if it’s $1,000,001 your heirs will be liable for a large tax bill.

In 2016, it is surprisingly easy for an estate to go over that number. Home values are much higher now than they were in 2006, when the current $1 million exemption was first set, and life insurance policies – particularly whole life and universal life policies that are becoming very common as financial planning instruments and large term policies that younger individuals can buy for low cost – can easily take up whatever exemption amount is left over.

An ILIT removes the life insurance policy from the estate entirely, by changing ownership of the policy from the insured to a trust. The beneficiaries of the trust are the beneficiaries of the life insurance policy. Because of these structural changes, the strategy has its drawbacks, the most prominent of which are:

  1. You give up control. You must place the trust in the hands of a trustee who is not yourself.
  2. You need a lawyer. These trusts are too complex, and the possible errors too consequential, to handle on your own or with the use of a legal forms web site.
  3. Everybody involved must be mutually trusting. The trustee will have a high degree of control over a substantial asset, and the beneficiaries must be trusted to properly handle yearly Crummey notices – a complex topic on which your estate planning lawyer can advise you.
  4. The uses to which you can put your policy are limited. For example, you cannot access or borrow against the cash value directly, but only in more complex ways requiring the trustee’s cooperation.

The best time to consider an ILIT is before purchasing an insurance policy. A new policy may be placed directly into the ILIT and potential tax savings will exist from day one. An existing policy may be retitled from individual ownership to an ILIT but there is a three year waiting period before the tax advantages become effective.

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