How to Protect Life Insurance Proceeds from Taxation
If you have been responsible enough to purchase a life insurance policy as added protection for your loved ones, then you will want to carry that responsible action a little further by protecting that important payout from taxation.
If you are married and have named your spouse as the beneficiary of your life insurance policy, those proceeds will pass free of both income taxes and estate taxes. However, if your children are named as beneficiaries, the proceeds are free of income tax, but they do become part of your taxable estate. Estate taxes have ranged from 35% up to 55% in recent years, so that’s a big bite.
An Irrevocable Life Insurance Trust (ILIT) is a great asset protection tool that protects your life insurance from estate taxes, and when drafted properly, can also be used to protect proceeds from creditors, bankruptcy and divorce.
The best way to use an ILIT is to have the Trustee of the life insurance trust purchase the life insurance directly and pay all premiums. If you already own the life insurance, your ILIT Trustee can either buy the policy for you, or you can transfer it in, by following certain rules we can help you with.
So why is this a good idea? The proceeds from the life insurance are not part of your estate if the ILIT owns the life insurance. Therefore, they are not subject to estate tax upon your death.
If you have not yet purchased life insurance, you should create your ILIT first. Have your ILIT purchase the life insurance. This will circumvent the transfer of life insurance from you to another party, thus avoiding any difficulties if you do unexpectedly pass away since the proceeds of your life insurance policy would revert to your estate if you died within three years of the transfer.
The ILIT is a phenomenal tool for protecting your life insurance from taxation, leaving behind more for your loved ones.
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