An Irrevocable Life Insurance Trust (ILIT) is a trust set up to hold ownership of your life insurance policies. There are three primary reasons why an ILIT might be right for you.
- Avoiding Estate Taxes – Unless you take steps to prevent it, the proceeds of your life insurance policies are included as part of your estate for determining estate taxes. This may not be an issue unless your estate is above the estate tax exclusion amount ($5.43 million for tax year 2015), but a large life insurance policy may put you near or over the threshold.
By establishing an ILIT, ownership is transferred to the trust and the policy is no longer considered as part of your estate. The ILIT becomes the beneficiary of your life insurance policy, and your intended beneficiaries of the life insurance policy become the beneficiaries of the ILIT. Your beneficiaries are taken care of, and estate taxes are bypassed.
- Asset Protection – An ILIT makes it extremely difficult, if not impossible, for creditors to access your life insurance assets in case of legal actions.
- Regulation of Beneficiaries – If a beneficiary is a minor or has irresponsible tendencies such as gambling or drug use, setting up your life insurance through a trust can ensure that the trustee can regulate the assets per your wishes under the conditions set up in the trust document.
You cannot be the trustee, although you can make your spouse or children trustees. It is probably a cleaner break to choose someone else as a trustee, such as a bank or other financial institution, even if a fee is involved. Having family members as trustees could be construed as your “incident of ownership” over the policy that puts the policy back into your estate.
Usually ILITs are unfunded, where there is no other property included in the trust that can be used to make the premium payments. You, as the grantor, make transfers of cash to the trust during your lifetime to pay the premiums (you do not own the insurance anymore, so the payments must come through your trustee).
These premium payments will be considered as gifts to the ILIT and will be subject to gift taxes if the amount is above the annual gift tax exemption ($14,000 per beneficiary for tax year 2015). Lifetime limits also apply.
An important element of the ILIT is the Crummey powers granted to the trust beneficiaries. Named for a court case on the issue, Crummey powers allow beneficiaries the right to withdraw the annual cash transfers to the trust during a short window of time. Beneficiaries must be notified of this right. Of course, the point is for the beneficiaries to decline to withdraw the transfers and for the trustee to use the cash transfers for premium payments as intended — but just having the ability to do so allows the transfers to qualify for the gift tax exclusion.
You can also transfer an existing policy into an ILIT, but there is a three-year waiting period for the ILIT to take effect. Should you pass away during the waiting period, your insurance policy will still be subject to estate taxes. Consult a qualified professional and understand the ramifications of each path to avoid running afoul of tax laws.
Make sure that you understand all the ramifications of an ILIT before you enter into one, and seek qualified financial and legal professional guidance in putting the ILIT together. Remember that the first “I” stands for irrevocable, meaning once the ILIT is established, it cannot be undone or altered.
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