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Retired Military Finances 301: ILITs Thumbnail

Retired Military Finances 301: ILITs

Insurance Estate Planning

I often hear (normally from insurance agents) that life insurance is tax-free. That is only partially true. Life Insurance proceeds are not subject to income tax. They are however potentially subject to estate taxes. Now for the last 10 years or so, estate taxes haven't been an issue for most retired Senior Military Officers and NCOs. I'm not sure, but that could change with the current (2021) administration and Congress. While it is too early to take action, it isn't too early to learn about options to legally avoid estate taxes on life insurance proceeds.

Life Insurance and Estate Taxes

As I mentioned above Life Insurance proceeds from policies owned by the decedent are part of the decedent's taxable estate. If that estate exceeds the estate tax exemption, the portion that does exceed the exemption will be subject to estate tax. Currently the estate tax maxes out at 40% for estates that exceed the exemption by $1M or more.

It is worth noting that there is an unlimited marital exclusion so your spouse receive Life Insurance proceeds and other assets with no estate tax due regardless of the size of your estate. That won't be true when your spouse dies, so ultimately the life insurance proceeds still could be subject to estate tax.

If anyone other than your spouse is the beneficiary of your Life Insurance policy, the proceeds are part of your taxable estate.

Enter the ILIT

ILIT stands for Irrevocable Life Insurance Trust. Here is how it basically works:

  • You establish an ILIT with your estate planning attorney
  • You transfer money to purchase a life insurance policy or a life insurance policy to the ILIT. You can't undo this (hence the word irrevocable)
    • If the transfers are greater than the annual gift tax exclusion you'll need to file a gift tax return
      • If you transfer a Life Insurance policy, the cash value is the amount you use to determine if you exceed the annual exclusion
      • If you transfer cash, that is the value you use. In both cases, two spouses can contribute twice the annual exclusion
  • The ILIT is named as the beneficiary of your insurance policy
  • The trust document setting up the trust, specifies how the life insurance proceeds can be used
    • Surviving spouse can be beneficiary with other individuals named as beneficiaries after the surviving spouse passes
  • You continue to gift funds to the ILIT to pay the premiums going forward to keep the policy in force

It's Not that Simple Though

That is a very simple explanation. As with all things estate planning and tax planning related, the devil is in the detail. Here are some things you need to watch for

  • There is a 3-year look back (for all gifts). If you set up the ILIT within 3 years of your death, assuming the insurance policy is on you, the Life Insurance proceeds will be included in your taxable estate
  • You need to really give up control of the insurance policy (for instance, you can't change the beneficiary(ies))
  • Funding needs to be done very carefully

The best way to make sure you dot all the i's and cross all the t's is to work with a competent estate planning attorney.

Military Finances are Different

While this subject applies to all Americans, that isn't always the case. There are a lot of differences between financial issues facing active and retired military members and civilians. That's why we think you should work with a financial planner that deals with military and veteran finances each and every day. If you'd like to chat, give us a call or sign up for a free initial consultation.

If you found this article useful, you might like the following blog posts:

Inherit the Family Home? Tax Consequences for Military Officers

What Happens If a Military Officer Dies Without a Will

What Military Officers Need to Know About TSP and Estate Planning

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