“Learn about an Irrevocable Life Insurance Trust (ILIT)”
05/05/14 By Matthew S. Dana
An Irrevocable Life Insurance Trust, commonly called an ILIT, is a unique legal document to help keep the proceeds of a life insurance policy outside of the estate and thus potentially free of estate tax and income tax. The ILIT is a legal entity that becomes operational while one is still living. The trust becomes the owner of the life insurance previously owned or of a new policy purchased in the trust’s name. Because the policy is owned by this legally independent trust, you would not be the legal owner of the proceeds, which therefore are not included in your taxable estate.
Irrevocable Life Insurance Trust (ILIT)
- Remove life insurance proceeds from your taxable estate
- Provide tax-free liquidity to your estate
- Preserve real estate, family business or other illiquid assets
- Use life insurance proceeds in coordination with charitable gifting
- Maximize inheritance while minimizing taxes paid to the federal and state governments
Q: What is an Irrevocable Life Insurance Trust (ILIT)?
A: The name itself gives you a good idea of what an Irrevocable Life Insurance Trust is all about. It is a trust established for the primary purpose of purchasing and maintaining one or more life insurance policies. Typically the insurance policy is on your life, as the Settlor of the trust.
Q: What are the benefits of establishing an ILIT?
A: The major benefit of establishing and funding an ILIT is that all proceeds of the insurance policy are excluded from your gross estate for federal estate tax purposes upon your death.
Q: Aren’t life insurance proceeds tax-free anyway? Why do I need this trust?
A: While it is true that life insurance proceeds are not taxed as income, the proceeds of an insurance policy may be included in your gross estate for federal estate tax purposes. If you possess what the IRS terms “incidents of ownership” of the policy, the proceeds will be included in your gross estate and taxed accordingly. You possess any of these “incidents of ownership” if you are the owner of the policy, have the ability to change the policy’s beneficiaries, can surrender, assign, or cancel the policy, borrow cash, surrender value, or otherwise pledge the policy, or if you own a majority of a corporation which is the owner of the policy. This list is not all-inclusive, but simply illustrates that simply purchasing a life insurance policy will not necessarily provide tax-free benefits to your heirs. For instance, if you are in the 53% estate tax bracket, a policy with a face value of $1,000,000 will only benefit your heirs by $470,000 because of the tax that must be paid to the government on the proceeds!
Proper drafting, funding, and administration of an Irrevocable Life Insurance Trust will allow the full $1,000,000 face value of the policy to benefit your heirs.
Q: How does an ILIT work?
A: There are two ways to establish and fund an ILIT. The first, and best, way to do this is by establishing the ILIT first, and then allowing the ILIT to purchase the life insurance. The second method is by establishing an ILIT and contributing an existing life insurance policy to the ILIT.
Establishing the ILIT first is preferable, because doing so will allow you to avoid any gift tax on the funding of the trust. You, as the Settlor, make contributions to the ILIT. The trustee then takes the contributions and uses them to pay the premium on the life insurance policy. In order to avoid gift tax on the contribution to the ILIT, the trust agreement must be properly drafted, and several technical steps must be followed.
If you have an existing policy, you may establish your Irrevocable Life Insurance Trust and contribute the existing policy to the ILIT. Doing so will result in a taxable gift, although you may use part of your lifetime gift tax credit to avoid paying any gift tax on the transfer. The amount of the gift will depend on whether it is a term or whole life policy.
Upon your death, the trustee of the ILIT files the claim for the death benefits. The insurance company issues the check to the ILIT, and the policy proceeds are excluded from your gross estate. The terms of the ILIT should allow the trustee to make loans to, or purchase assets from, your estate. This provides liquidity to the estate for payment of any estate taxes, and prevents a forced sale of assets which may be illiquid or your heirs do not wish to sell.
Q: Can I be the trustee of my Irrevocable Life Insurance Trust?
A: No. Being the trustee of your own ILIT will cause the proceeds of the policy to be included in your gross estate. You also should not choose your spouse as the trustee. A trusted family member, accountant, or financial institution may be good choices as trustee of your ILIT.
Q: Are there any disadvantages of establishing an ILIT?
A: One disadvantage of an Irrevocable Life Insurance Trust is that, as the name suggests, the trust is irrevocable. That is, you may not change the beneficiaries of the trust once it is established.
Another potential disadvantage is that, unless you have an existing policy, you will need to apply and qualify for life insurance for the trust to purchase. Depending upon your health, the premiums may be prohibitively expensive, or you may not qualify at all. It is important to investigate the potential premium payments and compare them to the estate tax savings while in the process of establishing your ILIT.