You're unsure whether life insurance
proceeds will be tax free
Typically, proceeds from life insurance policies are income-tax free. The bigger risk is that life insurance proceeds will be subject to estate taxes. If you own a policy on your own life – or even retain any "incidents of ownership," such as the right to change beneficiaries or the right to borrow the proceeds will be included in your taxable estate.
A highly effective way to avoid estate taxes on life insurance proceeds is to have an irrevocable life insurance trust (ILlT) hold the policy. You make periodic contributions to the trust to cover the premiums. When you die, the proceeds are paid to the trust estate-tax free and distributed to your beneficiaries according to the trust's terms.
Contributions are subject to gift tax, but in many cases they can be structured so that they fall within the $13,000 annual gift tax exclusion or lifetime exemption.
Ideally, you would establish an ILIT and have the trust purchase the policy. If you purchase th.e policy yourself and then transfer it to the ILlT, the proceeds will be pulled back into your estate if you die within three years after making the transfer. It may be possible to avoid this three-year rule, however, by selling a policy to the ILIT.
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