Irrevocable Life Insurance Trust
Individuals purchase life insurance for a number of reasons. Some do it as an investment. Others do it as a wealth planning strategy. If you purchase life insurance so that you can have liquidity to pay estate taxes, then the owner of your life insurance must be an irrevocable life insurance trust.
What Is an Irrevocable Life Insurance Trust (ILIT)?
A Trust is a contract between three parties – the settlor (the person who gives), the Trustee (the person who manages), and the beneficiary. Trusts can serve specific purposes. An irrevocable life insurance trust (ILIT) is a Trust that serves a special purpose. It is a Trust created to own a term, universal, or whole 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 irrevocable life insurance trust 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 irrevocable life insurance trust, like any other trust, has several parties: the settlor or grantor (person who acquires the policy), trustees (person who controls the policy and sends out crummey letters), and beneficiaries. The grantor typically creates the irrevocable life insurance trust. The gift to the Trust is typically permanent and, save a few exceptions, cannot be undone. The trustee manages the irrevocable life insurance Trust, and the beneficiaries receive distributions.
Once the Trust is set up, the Trust, the Trust should be the entity that actually acquires the life insurance. (Note that if the grantor transfers an existing life insurance policy to the irrevocable life insurance trust, there is a three year lookback period before the policy is considered to be “outside of the grantor’s estate.”) The grantor should give to the irrevocable life insurance trust the amount of premiums required to lock in the policy. The Trustee actually pays the premiums to the life insurance company. It is important for the grantor to avoid any incident ownership in the life insurance policy, and any premium paid should come from a checking account owned by the Irrevocable Life insurance trust.
Once established and funded, an ILIT can serve many purposes:
How Does an Irrevocable Life Insurance Trust Help Me?
Minimizes Estate Taxes
If you are the owner of the policy outright, then, upon your death, the life insurance policy will be included in your gross estate. However, when life insurance is owned by an irrevocable life insurance trust, then the policy is NOT includable in your estate and is not subject to state and federal estate tax.
If properly drafted the irrevocable life insurance trust can, following the grantor’s death, provide liquidity to help pay estate taxes. The funds in the life insurance trust, after payment of the estate taxes, can also be used to satisfy other debts and expenses.
Avoids Gift Taxes
A properly drafted irrevocable life insurance trust can avoid additional gift tax consequences. The premiums on the policy must be paid every year. The grantor of the irrevocable life insurance trust must still make contributions to the trust equivalent to the annual payments of the premiums. These additional contributions are considered additional gifts which can eat up the lifetime exemption unless the trustee sends out special letters to beneficiaries alerting the beneficiaries that a contribution has been made to the trust and that the beneficiaries have a certain time by which to make this withdrawal. These types of letters are known as Crummy letters. If these Crummey letters are sent out by the Trustee after the grantor contributes the premium payments to the trust and before the Trustee actually pays these payments to the life insurance company, then the additional contribution of the premiums is not subject to any gift tax. The trustee can then use the contributions to pay the insurance policy premium. The Crummey letter 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.
In 2020 and 2021, you can give $15,000 a year to as many people as you like. Therefore, depending on the number of beneficiaries in the Trust who are entitled to receive withdrawal rights and notices, you may be able to satisfy the premiums by using your annual exclusion. (Be careful of who you name as Crummy beneficiaries. You may want to consult an estate planning attorney about proper use of Crummies).
May Continue to Allow Receipt of Government Benefits
Having the proceeds from a life insurance policy owned by an irrevocable life insurance trust 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.
Provides Some 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 irrevocable life insurance trust is generally protected from the creditors of the grantor and/or beneficiary. The creditors may, however, attach any distributions made from the ILIT.
The trustee of an ILIT can have discretionary powers to make distributions and control when beneficiaries receive the proceeds of your 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 the discretion to provide distributions when beneficiaries attain certain milestones, such as graduating from college, buying a first home, or having a child. It’s really up to you. This can be useful in second marriages to ensure how assets are distributed or if the grantor of the trust has children who are minors or need financial protection.
What are the Tax Considerations of an Irrevocable Life Insurance Trust?
Irrevocable trusts have a separate tax identification number and a very aggressive income tax schedule. However, the cash value accumulating in a life insurance policy is free from taxation as is the death benefit. So there are no tax issues with having a policy owned in an irrevocable life insurance trust.
If properly designed, an ILIT can allow the trustee access to the accumulated cash value, by taking loans and/or distributions on a cost basis, even while the insured is alive. However, once a death benefit has been paid, if the proceeds remain in the trust, any investment income earned and not distributed to the beneficiaries could be taxed.
Irrevocable Life Insurance Trusts are a powerful tool that should be considered in many wealth management plans to help ensure that your policy is used in the best possible way to benefit your family. We can help you properly structure your life insurance trust.
Feel free to contact us for help with your life insurance trusts.
Additional resources provided by the author
For more information, please contact probate and estate planning attorney Regina Kiperman:
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