What is an irrevocable life insurance trust (ILIT)?
An irrevocable insurance trust (ILIT), which is a trust that an insured creates during their lifetime, owns and controls a term- or permanent life insurance policy or policies, is an irrevocable insurance trust. It can also distribute and manage the proceeds, which are paid out at the insured’s death.
An irrevocable trust for life insurance protects benefits from life insurance policies from estate taxes. It is irrevocable and cannot be undone or altered after it has been created.
An ILIT may own individual and third-to-die insurance policies. Second-to-die policies cover two lives and pay a benefit upon the death of the second.
Find out more about the seven main reasons to create an irrevocable trust for life insurance.
How an Irrevocable Insurance Trust (ILIT), Works
An ILIT is composed of several parties: the grantor and trustees as well as beneficiaries. The ILIT is usually funded and created by the grantor. The trustee is free to accept gifts or transfers to the ILIT that are permanent. The trustee oversees the ILIT and distributes funds to the beneficiaries.
It is crucial that the grantor does not own any incidental ownership of the life insurance policy. Any premiums paid should be made from a checking account belonging to the ILIT.
If the policy being transferred is of high accumulated cash value, there may be gifting issues. You should verify the insurability of the grantor before you pay the cost to have a trust created.
After the insurance company offers to make a new application for the trust, the trust can properly list the trust as the owner and replace the original application. The trust will then receive the policy.
An ILIT once it is established and funded can serve many purposes, including the following:
Minimizing Estate Taxes
If you are the insured and the owner of the policy, the death benefit from a life insurance policy is included in your gross Estate. However, if the life insurance policy is owned by an ILIT the proceeds of the death benefit are not considered part of the insured’s estate and are therefore not subject to federal and state estate tax.
The ILIT, if properly drafted, can provide liquidity to help pay estate tax, as well as other debts, and expenses. This can be done by buying assets from the grantor’s estate or taking out a loan. You can also reduce your taxable estate through lifetime gifts by transferring assets to the ILIT.
Avoiding Gift Taxes
An ILIT properly drafted avoids gift tax consequences because contributions made by the grantor are treated as gifts to the beneficiaries. It is essential that the trustee sends a Crummey notice to the beneficiaries of the trust advising them of their rights to withdraw a portion of the contributions within a period of 30 days in order to avoid gift tax.
The contributions can be used by the trustee to pay the premium after 30 days. Crummey letters qualify for a transfer for the annual gift exclusion. They make the gift a present interest and not a future interest. This avoids the need to file a gift return in most cases.
You can give $16,000 per year in 2022 (this will increase to $17,000 in 2023) to as many people as you wish. All gifts are included in the $16,000. An individual can receive $32,000 from a married couple (increased to $34,000 in 2023), tax-free. A married couple can give an individual $32,000 (increased to $34,000 in 2023) annually, tax-free.
You can also give more than $16,000 to someone (increasing up to $17,000 in 2023), with the excess going towards your lifetime estate tax exemption of $ 12.06 million for 2022 and $ 12.92 million in 2023. 1 4.
An ILIT may be able to hold the proceeds of a life insurance policy that is owned by a Trustee. This can help protect trust beneficiaries who are receiving government assistance such as Social Security Disability Income or Medicaid. So that beneficiaries are eligible for government benefits, the Trustee can control how to trust distributions are used.
Each state has its own rules and limits on how much cash value and death benefit can be protected from creditors. The creditors of the grantor or beneficiary are generally not protected if the coverage exceeds the limits in the ILIT. However, creditors can attach distributions from the ILIT.
An ILIT trustee can have discretionary power to distribute proceeds and control who beneficiaries are entitled to them. You can have the insurance proceeds paid immediately to any or all of your beneficiaries. You can also specify when and how beneficiaries will receive distributions.
A trustee may also be able to distribute distributions when beneficiaries reach certain milestones such as graduation, purchasing a home, or having children. You can decide what you want. This is useful for second marriages, to make sure assets are distributed and if the trust grantor has minor children or needs financial protection.
The generation-skipping tax (GSTT), imposes a 40% tax on outright gifts and transfers to or for unrelated persons who are less than 37.5 years older than the donor, or related persons more than one generation younger than them.
Gifting grandchildren to children is a common example. An ILIT is a way to leverage the generation-skipping transfer tax (GST) exemption of the trust grantor by using gifts to the trust for the purchase and funding of a life insurance policy.
Since the proceeds from the death benefit are excluded from the grantor’s estate, multiple generations of the family–children, grandchildren, and great-grandchildren–may benefit from the trust’s assets free of estate and GST tax.
Irrevocable Trusts have their own tax identification number and an aggressive income tax schedule. The death benefit and cash value in life insurance policies are exempt from tax. There are no tax concerns with a policy that is owned in an ILIT.
An ILIT, if properly designed, can give the trustee access to the accumulated cash value by taking loans or distributions on a cost basis while the insured is still alive. 6 7
What is the main downside to an irrevocable trust?
An irrevocable trust has one major drawback: Once the trust is established, there are no rights to make changes. The trust will not give you any rights to the assets that are placed in it. This could lead to serious consequences down the line. If you have a substantial amount of cash or a house that you intend to leave to your heirs, you may not be able to get them. An irrevocable trust may be dismantled by the courts in certain cases depending on the circumstances.
What happens to an irrevocable life insurance trust when the grantor dies?
The life insurance trust will continue to receive the benefits even after the grantor passes away. Benefits will then be divided among trust beneficiaries according to how the grantor determined when the trust was established.
What is the purpose of a Life Insurance Trust and how can it help you?
A life insurance trust’s main purpose is to lower the value of an individual’s estate to reduce estate tax. Trusts can also protect assets against creditors.
The bottom line
ILITs can be a powerful tool and should be included in wealth management plans. They will help you ensure your policy is being used in the most beneficial way for your family. Even with the exemption from federal gift and estate tax at $ 12.06 million in 2022 (which will increase to $ 12.92 million in 2023), you still have the option to owe state estate taxes. Many states tax your estate at $1,000,000 or less.