The cash value of life insurance policies can often catch households by surprise when it comes to estate planning. Yes, the stated death benefits are clearly high, but many beneficiaries simply assume that they will be given tax-free.
In truth, life insurance policies can trigger all sorts of tax complications, including those that arise well before the covered individual dies. The cash value of the policy is considered an asset, and a payout can trigger estate taxes if it ends up causing the estate value to exceed the covered individual’s lifetime estate tax exclusion.
The solution to this problem, for many New Mexico households, is to create an irrevocable life insurance trust (ILIT). This type of trust removes both the cash value and benefits from the covered individual’s estate.
By removing these factors, family members may be able to inherit their benefits tax-free.
An ILIT can also produce other notable advantages, including the ability to retain benefits and use them to fund other trust instruments, such as a special needs trust. Reach out to New Mexico Financial & Family Law to discuss your options and see if an irrevocable life insurance trust is the right option for you.
Schedule a no-obligation consultation with a New Mexico trust lawyer when you call 505-503-1637 or contact us online.
For the most part, an irrevocable life insurance trust is most likely to be useful to families who might exceed their lifetime estate tax exemption.
The current exemption amount is at an all-time high of $13.61 million per individual. This amount could revert to around $7.2 million at the end of 2025, once provisions of the Tax Cuts and Jobs Act of 2017 expire.
Nevertheless, some families of high net worth may eventually exceed this amount in an individual’s lifetime. They should reach out to an irrevocable life insurance trust lawyer to discuss their options for creating a trust and structuring it to suit their estate planning goals.
In addition, families not worried about exceeding their estate tax exemption may still find an irrevocable life insurance trust helpful. Normally, life insurance benefits pay out immediately to the named beneficiary (or beneficiaries).
With an ILIT, the trust itself can be named as a beneficiary instead. The money deposited into the trust can then be transferred to any number of beneficiaries at a later date.
It can also be used to purchase assets that can remain in the trust for years at a time, gaining value and producing an income stream.
The legal ramifications of an irrevocable life insurance trust can be complicated to understand, and the trust itself has to be set up precisely in order to capture the exact advantages desired. Speak to an experienced New Mexico irrevocable life insurance trust attorney to get started on the process and ensure that your trust is capable of delivering on your expected goals.
A New Mexico irrevocable life insurance trust is created when the policyholder transfers ownership of their policy to an irrevocable trust. They can also transfer cash to a trust instead, which can then be used to purchase a life insurance policy for the trust creator (called a grantor).
When the covered individual dies, the death benefit can be paid to the trust itself. The trustee will then follow instructions to either finance investments using the cash or transfer it to beneficiaries.
Importantly, these transfers do not count towards the gross value of the deceased individual’s estate — with one exception. If the decedent’s estate representative is named as a beneficiary of the ILIT, then any policy proceeds could be considered a contribution to the estate itself ( I.R.C. § 20.2042-1).
To pay for the premiums of a life insurance policy, the grantor can transfer extra cash into an irrevocable life insurance trust. However, these premiums could count as a gift since the trust will ultimately provide distributions to beneficiaries who are not the grantor.
To use an annual gift tax exemption instead, the grantor can use a Crummey trust provision to make the designated cash available as a present interest. If beneficiaries receive a letter of notice about their ability to access the cash but decline, the cash can stay in the trust and be used towards paying life insurance policy premiums each year.
For an ILIT to avoid counting towards the grantor’s gross estate (which would trigger estate taxes), the covered individual has to survive a minimum of three years from the time the policy was initially created.
If a grandchild or anyone else 37.5 years younger than the grantor receives a distribution from the ILIT, the transfer will likely not trigger a generation-skipping transfer tax (GSTT).
In addition to avoiding estate taxes, an irrevocable life insurance trust can also be used to customize how death benefits are transferred to loved ones.
As mentioned above, most life insurance policies pay out immediately after the death of the covered individual. These payments can be structured as a series of lump sums, or they can be arranged as an annuity.
Multiple beneficiaries can be listed, but the policyholder has to designate a specific percentage of the proceeds that would go to each beneficiary.
With an irrevocable life insurance trust, the proceeds of the policy can instead form a cash pool that can be used to purchase investment assets. These assets can produce income that would be provided to beneficiaries for a designated amount of years.
Even in the event that the proceeds of the policy are paid out in cash value to beneficiaries, according to the guidance of the ILIT, the grantor can create special rules limiting these transfers.
For example, a minor may only receive their distribution once they reach the age of 18 or only after they graduate with a bachelor’s degree. Family members may also be restricted from withdrawing money from the trust except for specific qualifying purposes, such as reasonable living expenses, medical costs, education costs, or funds needed because of an emergency.
One major advantage of creating an ILIT is that it protects the cash value of the policy and any eventual proceeds from potential creditor claims.
Normally, a life insurance policy can be used as an equity pool, allowing the policyholder to borrow against the current value of accumulated premiums and guaranteed death benefits. The ability to access these funds means that, in some cases, a creditor or recipient of a court award can force the policyholder to tap into their policy to repay debts.
An irrevocable life insurance trust removes the covered individual’s ability to borrow from the value of their policy. Technically, the trustee may have the right to make such a financial decision, but they will be given complete discretion in a properly structured ILIT.
Since the trustee cannot be forced to either withdraw from the cash value of the policy or transfer that cash to the grantor, the funds are generally safe from creditor claims.
However, in some situations, a creditor may be able to claim distributions from the trust. Speak to a New Mexico irrevocable life insurance trust attorney to determine if you will need to create additional protections to prevent this scenario from occurring.
The cash value of the life insurance policy, derived from the accumulated value of premium payments, is not subject to income taxes. The final death benefit is also not taxed, even though the trust or trustee is listed as the technical beneficiary.
Once a death benefit pays out, the trust may start to accumulate income if the proceeds are used to fund investments or are deposited in an account that earns interest. These gains in value are subject to income taxes.
The trust pays taxes on its own income (at a higher rate than individuals) unless these proceeds are designated to transfer to beneficiaries, who can instead report them as personal income.
Note that if the entire policy is sold before the covered individual passes, then the proceeds would not be eligible for an exemption from income or estate taxes.
A grantor trust allows the grantor to retain rights to distributions or other transfers. With an ILIT, the most common usage would be to generate income from capital generated by borrowing against the cash value of the policy.
This arrangement is allowed, but all income generated will trigger trust income or personal income taxes — including if the income is distributed to a spouse of the grantor while the grantor is still alive.
ILITs that do not produce income do not create these taxes.
Another major advantage to creating an irrevocable life insurance trust in New Mexico is that it can be structured in a way to benefit a minor or an adult with special needs.
When calculating eligibility for programs like Supplemental Security Income (SSI) and Medicaid, being the beneficiary of a life insurance policy can count towards your total calculable assets. In this way, the simple act of naming a disabled relative can hurt their ability to continue claiming benefits or qualify for programs like Medicaid long-term care.
Creating an irrevocable life insurance trust enables the value of the proceeds and the policy itself to not count towards a beneficiary’s total assets. In addition, once the death benefit is paid, the total amount designated for a beneficiary does not have to count towards their assets.
Instead, they can receive a limited income from the trust along with a certain amount of financial support for qualifying expenses. These expenses can include basic living expenses, co-pays, and medically necessary support.
Make sure to discuss planning with a New Mexico special needs trust lawyer if this is one of your goals. With the right forethought, your life insurance trust can help provide for vital medical care and living expenses without hurting your loved one’s needs-based eligibility.
Any liquid cash in an irrevocable life insurance trust — whether it came from death benefits or borrowing against the policy’s cash value — may potentially be used to purchase equivalent value assets from another source without affecting the protections created by the trust.
With this extra liquidity, families could purchase a beloved property from the estate and transfer it into the trust without triggering any additional estate taxes. The final effect is that the property can continue to be used as intended while cash is made available to pay for a funeral, burial, or estate administration costs.
As you can see, there are many possible uses and advantages to creating an irrevocable life insurance trust. With just one trust, you can maximize your use of life insurance proceeds while minimizing the money’s effect on estate taxes.
In addition, you can create special rules for the distribution of proceeds from the trust or finance the care of a loved one with special needs without affecting their eligibility for certain programs.
With the help of a New Mexico irrevocable life insurance law firm, you have many opportunities to make the most of one of your most important financial investments. Learn more about how to create an ILIT and use it to provide the most advantages during a no-obligation consultation with our experienced New Mexico estate planning attorneys.
Call 505-503-1637 or contact us online to schedule your consultation and estate plan review today.
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