There are many reasons people buy life insurance as it offers some unique features that are not found in many other financial products. For example, you can build cash value, over fund policies, and have access to tax free withdrawals. With many permanent polices, you also have access to accelerated benefits for long term care or critical care. One of the biggest benefits you can do, is buying life insurance in an Irrevocable trust. An Irrevocable Life Insurance Trust (ILIT) is created to own and control a term or permanent life insurance policy or policies while the insured is alive, as well as to manage and distribute the proceeds that are paid out upon the insured’s death. An ILIT can own both individual and second to die life insurance policies. Second to die policies insure two lives and pay a death benefit only upon the second death.
An ILIT has several participants; the grantor, the trustees, and the beneficiaries.
The grantor is the one who creates and funds the ILIT. Gifts or transfers made to the ILIT are permanent, and the grantor is giving up control to the trustee. The trustee manages the ILIT, and the beneficiaries receive distributions when the grantor passes. It is important for the grantor to avoid any incidental
ownership of the life insurance policy. Any premium paid should come from a checking account owned by the ILIT, not the grantor. If the grantor transfers an existing life insurance policy to the ILIT, there is a 3-year look back period in which the death benefit could be included in the grantor's estate.
Once built and paid for, an ILIT can serve many reasons such as:
Minimize Federal and State Estate Taxes. If you are the owner and insured, then the death benefit of a life insurance policy will be included in your estate. However, when life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured's estate and are not subject to estate taxation. A properly drafted ILIT can provide liquidity to help pay estate taxes, as well as other debts and expenses, by purchasing assets from the grantor’s estate or through a loan. This is one of the main reasons to use an ILIT.
Avoid Gift Taxes. A properly constructed ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries. To sidestep gift taxes, it is crucial that the trustee, using a Crummey letter, notify the beneficiaries of the trust of their right to withdraw a share of the contributions for a 30-day period. After 30 days, the trustee can then use the contributions to pay the insurance policy premium. The Crummey letter(Download a template here) qualifies the transfer for the annual gift tax exclusion by making the gift a present rather than future interest, thus avoiding the need in most cases to file a gift tax return. It is a technicality that many fail to satisfy.
Taxes. Irrevocable trusts have a separate tax identification number (TIN) and has a very aggressive income tax burden. However, the cash value accumulating in the policy is free from taxation just like the death benefit. If properly constructed, an ILIT can allow the trustee full access to the accumulated cash value, by taking loans and/or distributions at cost basis, even while the insured is alive.
Asset Protection. Each state has different rules and limits regarding how much cash value or death benefit is protected from creditors. Any coverage above these limits held in an ILIT is generally protected from the creditors of the grantor and/or beneficiary. The creditors may however attack any distributions made from the ILIT, so be careful. Assets of an ILIT could also generally be immune from claims in a divorce or dissolution of marriage. An ILIT may also provide for termination of a spouse’s interest in the event of remarriage.
Distributions. The trustee of an ILIT can have discretionary powers to make distributions and control when beneficiaries receive the proceeds of the policy. The insurance proceeds can be paid out immediately to one or all of your beneficiaries or you can specify how and when beneficiaries receive distributions. The trustee can also have discretion to provide distributions when beneficiaries attain certain milestones, such as buying a home or having a child, or even something like graduating. It’s really up to the trustee. This can be useful in second marriages to ensure how assets are distributed or if the grantor of the trust has children and want to make sure their children from the first marriage are taken care of.
Government Benefits. Having the proceeds from a life insurance policy owned by an ILIT can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid. The Trustee can carefully control how distributions from the trust are used so as not to interfere with the beneficiary's eligibility to receive government benefits. Then from there, the trustee may be able to set up a special needs trust to help the beneficiary continue to receive government benefits.
Legacy Planning. The generation-skipping transfer tax (GST) imposes a tax of 40% on both outright gifts and transfers in trust to or for the benefit of unrelated persons who are more than 37.5 years younger than the donor, or to related persons more than one generation younger than the donor. A common example is gifting to grandchildren instead of children. An ILIT helps leverage the grantor of the trust’s generation-skipping transfer (GST) tax exemption by using gifts to the trust to buy and fund a life insurance policy. Since the proceeds from the death benefit are excluded from the grantor’s estate, multiple generations of family -- children, grandchildren and great grandchildren -- may benefit from the trust assets free of estate and GST tax.
ILITs are a seriously powerful tool that needs be considered in many financial plans. ILITS help ensure that the policy is used in the best possible way to benefit your family exactly how you wish proceeds to be used. Even with the federal estate and gift tax exemption at $5.43 million, it is still possible to owe state estate taxes. Many states begin taxing your estate at $1 million or less. ILITs have some technical rules that your estate planning lawyer can further explain to you. Using an ILIT is a simple way to protect your family and lower your estate tax burdens. If you have any questions about this, don’t hesitate to call. Run all this by your tax attorney and CPA before you implement any of these strategies.