Estate Planning with Life Insurance Policies: Are Your Policies Worth Keeping?

A common estate planning technique which attorneys use is the creation of an irrevocable life insurance trust, or “ILIT”.  The purpose of an ILIT is to minimize the impact which life insurance proceeds can have in terms of estate tax.  While most people understand that death benefits paid out from a life insurance policy to named beneficiaries are not subject to probate, these proceeds are included in a person’s taxable estate for estate tax calculation purposes.  If, however, the policies are owned within an ILIT, which has name trust beneficiaries and an independent trustee charged with managing the trust, paying the policy premiums, and the like, upon the death of the grantor, these proceeds are excluded from the grantor’s taxable estate. 

There is a catch, however, to this exclusion.  If a grantor contributes existing policies to the ILIT, the IRS can “claw back” the proceeds into the grantor’s taxable estate for three years after the date of transfer, and I often joke with my estate planning clients that they have to make sure to survive for three years after we create the ILIT; otherwise, the client’s purpose in creating the ILIT will be frustrated.

A simple way to avoid this result is to place new policies at the time the ILIT is created, as the proceeds from new policies purchased within the ILIT are immediately excludable from taxable income. 

Just recently I met a gentleman named Bob Cohen, a principal at Tamar Fink in Minneapolis.  Bob calls himself an “insurance only” insurance agent and he explained to me how he offers a no-cost “insurance audit” for prospective clients.  This audit involves Bob reviewing an existing insurance policy and determining whether the policy’s actual performance comports with the expected rates of return determined at the time of purchase of the policy.  If the policy is underperforming – meaning that the policy premiums will not support the policy for the life of the policy – Bob is able to replace the underperforming policy with one that has a better rate of return. 

My discussion with Bob prompted this question:  if you are going to form an ILIT, given the three year clawback rules, and if you are going to transfer existing life insurance policies to the ILIT, shouldn’t you have an insurance agent “audit” these policies prior to transfer to determine if their actual vs. expected rates of return justify using these policies (in other words, are the policies’ performance sufficient enough to justify the risk of clawback), or should the policies be cancelled and replaced with new policies which would be immediately excluded?  If you’re talking to an agent who is set up to perform such an audit and is offering to do so at no extra cost, it seems to me that the answer to this question is that an audit of these policies is a no-brainer.