The proceeds from a life insurance policy are generally subject to the estate tax. You can remove them from your taxable estate by transferring policy ownership. If you wait too long, however, this tactic might not work. If you die within three years of the ownership transfer, the proceeds will be considered part of your taxable estate.

Avoiding “Incidents of ownership”

To avoid the proceeds of a life insurance policy being considered part of your taxable estate, you need to make sure that you don’t retain any “incidents of ownership.” For example, you’re treated as having incidents of ownership if you have the right to:

• Designate or change the policy’s beneficiary
• Borrow against the policy or pledge any cash reserve
• Surrender, convert or cancel the policy OR
• Select a payment option for the beneficiary

Transferring your policy effectively eliminates these incidents of ownership. But before you can transfer a policy, you need to decide to whom to make the transfer. When making this decision, it’s important to evaluate why you hold a life insurance policy in the first place—whether to replace lost income, provide liquidity, or transfer wealth to your heirs

What is the ILIT option?

One of the best alternatives to ownership is something known as an ILIT, or an irrevocable life insurance trust. You can exclude a policy from our estate by transferring complete ownership of the policy to an ILIT, as long as this happens at least three years before your death. You should designate the administrative duties to a trustee such as a family member, friend, or a trusted professional. An ILIT can also acquire additional life insurance protections from the outset should this be something that you need.

ILITs have many estate planning uses. They can protect assets from creditors or from relatives who you might not want to have free reign with liquid cash. They also keep the proceeds of the policy from needing to pass through probate by naming a beneficiary—in the case of an ILIT, the beneficiary is the ILIT itself. 

Act early

If you are planning to transfer ownership on your life insurance policy, it’s better to make the transfer sooner, rather than later. 

Contact your trusted Smolin professional with any questions regarding life insurance in your estate plan or ILITs.