Life insurance can provide a critical financial safety net for your loved ones if you die unexpectedly. But, if you do not plan accordingly, it can also create a substantial tax burden (eliminating many of the benefits your policy was designed to provide), and it can potentially lead to other issues for your surviving spouse, children, or other beneficiaries. As a result, buying life insurance is not something that should be done in a vacuum. Rather, when you buy life insurance (or, really, before
you buy life insurance), you should make sure you have a plan in place that maximizes the benefits and minimizes the burdens for your family.
One of the best ways to do this is to establish an irrevocable life insurance trust (ILIT). An ILIT is a special type of trust that is specifically recognized for life insurance planning purposes. When you establish an ILIT, the trust holds your life insurance policy; and, when you die, the proceeds of the policy go into the trust rather than your personal estate.
5 Benefits of Establishing an Irrevocable Life Insurance Trust
Why is this so desirable? For most people, there are several benefits to establishing an irrevocable life insurance trust. These include:
1. ILITs Reduce (or Eliminate) Estate Tax Liability.
If you die with more than $5.49 million
in your taxable estate, your estate will owe a tax of up to 40 percent on the assets that exceed this exemption amount. If you accumulate wealth during your lifetime, a substantial life insurance payout could easily push the value your estate well above the taxable threshold. To avoid having 35 to 40 percent of your life insurance proceeds going directly to the federal government, you can use an irrevocable life insurance trust to keep the proceeds out of your taxable estate.
2. ILITs Reduce the Coverage You Need.
If you have to plan for a significant portion of your life insurance proceeds going to the Internal Revenue Service (IRS), you need to buy more coverage to ensure that your family’s finances will be secure. For example, suppose you want to make sure your spouse receives a $2 million payout upon your death. If you use an ILIT to avoid estate tax, you only need a $2 million policy. But, if you own the policy in your own name and the payout exceeds your estate tax exemption, you would need almost $3.4 million worth of coverage to pay 40 percent to the IRS and still have $2 million left over for your spouse.
3. ILITs Give You More Control Over the Distribution of Life Insurance Proceeds.
When you buy a life insurance policy, you have the ability to name one or more beneficiaries. When you die, these beneficiaries receive a lump sum payment from the insurance company. But, what if this is not exactly what you want? For example, what if you have young children, and you do not want them to receive a financial windfall before they have the ability to manage it effectively? By establishing an ILIT, you can provide financial security while also making sure that the proceeds of the policy will be managed appropriately with your children’s long-term best interests in mind.
4. ILITs Help Insulate Your Life Insurance Proceeds from Creditors.
Irrevocable trusts are some of the best domestic tools available for protecting assets from creditors, and this holds true for ILITs. By holding your life insurance policy in an ILIT, not only are you taking the policy out of your name, but you are also necessarily relinquishing a certain amount of control due to the irrevocable nature of the trust. These are both key aspects of a legally-enforceable asset protection strategy
, and they can help ensure that the financial security you have paid for with your policy does not end up getting lost to business, personal, or judgment creditors.
5. ILITs Help Protect Beneficiaries’ Existing Benefits.
Eligibility for many government benefit programs is contingent upon the participant falling below a certain income threshold. If a beneficiary of your life insurance policy is receiving government benefits, a lump-sum payment could result in ineligibility. This issue can be avoided with an ILIT, with the trust retaining ownership of the insurance proceeds and managing them for the benefit of your loved one.
Steps Involved in Establishing and Managing an ILIT
The steps involved in establishing an ILIT are much the same as those for establishing other types of trusts. However, there are some unique aspects of ILITs that require careful planning and attention:
- Name the Trustee – You will need to choose an individual or firm to manage your ILIT. This person (or company) is known as the “trustee.”
- Name the Beneficiary(ies) – You must also choose the individuals (typically family members) or charitable organization(s) that will be entitled to the proceeds of your life insurance policy upon your death. You will want to choose your beneficiaries and grant them withdrawal rights in a manner that is consistent with your overall estate planning goals.
- Choose Your Life Insurance – You need to find a life insurance policy that best suits your individual needs. If you already have coverage, you may be able to transfer your existing policy into your ILIT. However, there is an IRS rule which states that if you die within three years, the policy will revert to your personal estate. As a result, unless you are no longer insurable or cannot afford a new policy, it is generally best to have the ILIT purchase new coverage.
- Fund the Trust – In most cases, individuals fund ILITs with lifetime gifts which the trustee then uses to pay the premiums. Or, they may gift income-producing assets to the trust so that the trustee can use the income to keep the policy in effect. Another option is to grant “Crummey powers,” which allow limited rights for beneficiaries to withdraw trust assets without creating tax liability.
Is an ILIT Really “Irrevocable”?
Is an ILIT really irrevocable? Technically speaking, yes. Once you establish an ILIT, you cannot pull your life insurance policy out of the trust, and you cannot seek to recollect any cash or other assets you have gifted to the trust.
However, in appropriate circumstances, it may be an option to simply let your coverage lapse. If you decide that you no longer need life insurance (which is a decision you should make with the guidance and advice of an experienced advisor), you may be able to stop funding the trust. Of course, you will lose the benefit of any premiums paid to date as well as the costs incurred in establishing your ILIT; but, if this is the best option, it is the best option. If you come to a point where you are considering terminating your life insurance coverage and ceasing to use your ILIT, you should be sure to carefully assess all of the benefits (including the asset protection benefits) of your ILIT as well as the implications for the rest of your estate plan.
Should You Establish an ILIT? Schedule an Initial Consultation
If you have questions about life insurance, estate planning, or asset protection strategies, we can help you make informed decisions. To get started with a confidential initial consultation, please call (646) 389-5065 or inquire online
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.