An irrevocable life insurance trust, or ILIT, is a special type of irrevocable trust. It can be used to help avoid paying estate tax due to large life insurance policy proceeds. In this article, we will go over the basics of how an irrevocable life insurance trust works.
The Basics
When you create an irrevocable life insurance trust, you set it up for the sole purpose of owning a life insurance policy. You can have the ILIT own the policy by transferring the ownership to it after you purchase the policy. Or you can have the trust purchase the policy itself. Since it is an irrevocable trust, you will not be able to change or revoke it after you sign it into effect.
You also cannot have any incidents of ownership over the policy. Incidents of ownership include such abilities as being able to withdraw cash value or change beneficiaries. This means you cannot be the trustee of the trust. However, your spouse or children can be trustees.
Estate Tax
The 2018 estate tax threshold is $11.18 million, per estate. Any amount of your estate that is over the threshold is subject to estate taxes. If you had a $7 million estate, plus a $5 million insurance policy, $1 million of your estate would be subject to estate taxes.
You should also be aware of your state’s estate taxes. Some states have their own threshold and they are often lower than the federal level. If this is the case in your state, you should use your ILIT to plan accordingly.
Beneficiaries
Your irrevocable life insurance trust should be the primary beneficiary of your life insurance policy. At your death, the policy benefits will be paid to your ILIT and follow the distribution provisions that you left behind there. If the benefit is to go to your spouse, and you think that money will be left behind at their death, you should not give them a lump-sum distribution. Instead, you should have their distribution set up through regular, incremental payments. This will prevent the remainder of the policy from being part of your spouse’s estate.
Factors to Be Aware Of
It is important to note that if you die within three years of transferring ownership to your ILIT, the IRS could still include the policy benefit in your taxable estate. However, you can completely avoid this issue by having the trust purchase the life insurance policy and fund the trust with a sufficient amount to make the premium payments.
Additionally, you also need to be careful so as to avoid paying gift taxes on the funds you transfer into the trust. You can avoid this by sending “Crummey” letter to all beneficiaries anytime you transfer funds into the trust. This letter gives them the option to take out their share of the funds deposited within a specific time period. Most beneficiaries waive this since the share of deposited funds is much smaller than their share of the life insurance policy benefit. As long as the beneficiaries have an immediate right to any money deposited, the gift tax will not apply.
Dissolution
Unfortunately, an irrevocable trust cannot be dissolved or amended once they have been signed into effect. But, if you allow your life insurance policy to lapse, there is nothing to fund the trust. Thus, leaving it empty and without purpose.
Creating an Irrevocable Life Insurance Trust
If you feel that an irrevocable life insurance trust is right for you, then the next step is to have one created. Meet with someone who has experience in estate and tax planning, so they are able to help you successfully create and fund your trust.
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