Divorce or separation agreements often require one spouse to maintain life insurance as security for their support obligation. Attorneys often do not address the tax implications if the insured spouse owns the policy.
Often life insurance will create an estate tax that would NOT otherwise exist by adding a windfall to the insured’s estate upon death. The death benefit of a life insurance policy owned by the insured spouse will be included in his or her estate for estate tax purposes. When the insured owns his or her life insurance policy, he or she has “incidents of ownership”, such as withdrawing cash value, assigning the cash value as collateral, or changing the beneficiary during his or her lifetime.
In order to keep the death benefit OUT of the insured’s estate for estate tax purposes, the insured can create an Irrevocable Life Insurance Trust, commonly referred to as an ILIT.
Once created, the Trustee of the ILIT will own the life insurance policy, NOT the insured. As a result of having the ILIT own the policy, the insured avoids incidents of ownership and the tax implications associated therewith.
The ILIT will also be the beneficiary of the life insurance policy resulting with the death benefit being held for the ex-spouse, children or other beneficiaries until certain ages, and can provide liquidity to an insured’s taxable estate, without having the death benefit itself be exposed to estate tax.
Should the insured pass away before a support obligation is complete, the death benefit related to the support for the benefit of the ex-spouse would be administered by the Trustee of the ILIT pursuant to the terms of the Marital Settlement Agreement/Judgment. The residue of the death benefit, if any, would pass to the other named beneficiaries via the ILIT with no Court proceeding.
