Irrevocable Life Insurance Trusts: Estate Liquidity And Protection

An irrevocable life insurance trust (ILIT) is a powerful estate planning tool that can be used to manage financial issues around life insurance assets and benefits. It can be the easiest and most efficient way to pay estate taxes, prevent the need to sell high-value assets, and provide liquidity to an estate.

An ILIT is its own legal entity with a separate tax ID number. It involves three parties: the grantor, who funds the trust; the trustee, who manages it; and the beneficiary, who will receive the assets.

When setting up an ILIT, the grantor places a life insurance policy inside the trust, meaning the trust owns the policy, not the grantor. As an irrevocable trust, once the life insurance is owned by the trust, it cannot be transferred back without the consent of the trustee and beneficiaries.

The trustee is responsible for managing payouts to the beneficiaries and ensuring the grantor's wishes are followed.

By placing a life insurance policy in an ILIT, the payout is excluded from the grantor's estate, which can lead to major tax savings when passing on assets to heirs. The proceeds from the policy can also provide liquidity to the estate, avoiding the need to sell assets to pay taxes or other expenses.

In addition to tax benefits, an ILIT provides privacy during estate settlement, as trusts do not require judicial approval through the public probate process. It also gives the grantor more control over how the proceeds are distributed and can protect insurance benefits from divorce, creditors, and legal action.

Estate tax reduction

An irrevocable life insurance trust (ILIT) is a highly beneficial tool for estate tax reduction. It is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy. The death benefit from a life insurance policy will be included in the gross estate of the owner and insured, but when an ILIT owns the policy, the proceeds are not part of the insured's gross estate and are thus not subject to estate taxation. This is a powerful way to preserve wealth and pass on money to heirs.

The ILIT involves three parties: the grantor (who funds the trust), the trustee (who manages the trust), and the beneficiary (who receives the trust property). The grantor makes a gift payable to the ILIT, and the trustee deposits the check into the trust's checking account, using the funds to purchase a permanent life insurance policy for the insured. The trustee then distributes the life insurance proceeds according to the terms of the ILIT.

There are several requirements for funding an ILIT. Firstly, the grantor cannot be the trustee, as this could lead to the trust being included in their estate. Secondly, the trust must own the life insurance policy. If the insured dies within three years of transferring an existing policy to the trust, the policy will still be considered part of their estate. To avoid this, the trust can purchase a new policy directly. Thirdly, funds need to be transferred to the trust to pay the policy premiums, which can create gift tax issues. To avoid this, a ""Crummey power"" can be used, giving beneficiaries the right to withdraw the funds for up to 30 days. After this period, the trustee can use the funds to pay the annual insurance premium.

While an ILIT can be an effective tool for estate tax reduction, it also has some downsides. Once the trust is finalised, no changes can be made, and any property placed in the trust is no longer the grantor's. Additionally, setting up and maintaining an ILIT can be complicated, and it is recommended to discuss this option with an attorney or financial planner.

Avoiding probate

An irrevocable life insurance trust (ILIT) is a powerful tool for avoiding probate. When a person dies, their estate may face a lack of liquidity to cover administration costs, debts to creditors, and estate taxes. This often results in heirs having to sell inherited assets to meet these obligations. An ILIT can provide the required liquidity to avoid this.

Life insurance proceeds are typically paid directly to the beneficiary and are not taxable as income. However, the value of the death benefit is included in the gross taxable estate of the insured for gift and estate tax purposes. An ILIT is designed to exclude the value of the life insurance death benefit from the gross taxable estate. This is achieved by making the trust the owner and beneficiary of the life insurance policy during the insured's lifetime.

By using an ILIT, the proceeds of the life insurance policy are held outside of the estate, and the beneficiaries do not have to share any portion of the proceeds with the IRS. This allows the insured to keep assets that are part of the taxable estate intact for their beneficiaries. For example, this can be useful for ensuring that a family is not forced to sell real estate to pay estate taxes.

The main goal of an ILIT is to provide liquidity to the insured's estate upon their death and/or to pass on death benefit proceeds to the insured's beneficiaries free of federal estate taxes. The trustee of the ILIT is responsible for following the terms of the trust and can use the proceeds to loan money to, or purchase assets from, the insured's estate.

The ILIT is an effective way to avoid probate and estate taxes without the problems associated with transferring ownership of the policy to the insured's children or heirs. However, it is important to note that the law surrounding ILITs is complicated, and it is recommended to consult an attorney or financial advisor to determine if an ILIT is suitable for an individual's specific circumstances.

Protecting assets

In addition, an ILIT can protect assets from creditors. Each state has different rules and limits regarding how much cash value or death benefit is protected from creditors, but any coverage above these limits held in an ILIT is generally protected from the creditors of the grantor and/or beneficiary.

An ILIT can also be used to protect assets for distribution control. The trustee of an ILIT can have discretionary powers to make distributions and control when beneficiaries receive the proceeds of your policy. For example, if you are worried about beneficiaries receiving a lump sum, you can arrange for the trust to release smaller, timed instalments instead. This can also protect the beneficiary so that there are no conflicts that would jeopardise government benefits they may already be receiving.

Avoiding gift taxes

An Irrevocable Life Insurance Trust (ILIT) is a type of irrevocable trust that is created during the insured's lifetime. It owns and controls a term or permanent life insurance policy, and can manage and distribute the proceeds that are paid out upon the insured's death, according to their wishes.

ILITs are an effective way to avoid gift taxes. Here's how:

• The grantor makes a gift payable to the ILIT.
• The trustee deposits the check into the ILIT's checking account and uses the funds to purchase a permanent life insurance policy for the insured.
• The trustee then notifies the beneficiaries of their right to withdraw a share of the contributions for a 30-day period, via a "Crummey letter". This qualifies the transfer for the annual gift tax exclusion, making it a present rather than a future interest.
• After 30 days, the trustee can use the contributions to pay the insurance policy premium.
• The annual gift tax exclusion for 2023 is $17,000 per individual and $34,000 for married couples, increasing to $18,000 and $36,000, respectively, in 2024.
• If the amount gifted to the ILIT exceeds the annual exclusion, the excess amount can still be given without federal gift tax liability by using the trustmaker's lifetime federal gift tax exemption.
• The number of ILIT beneficiaries is considered when calculating the federal annual gift exclusion. For example, if an ILIT has four beneficiaries, the trustmaker could gift $60,000 per year.
• The beneficiaries will not typically exercise their right to withdraw, as this would affect the ILIT's ability to pay the premium.
• The grantor can also make lifetime gifts to the ILIT to reduce their taxable estate.
• The proceeds from a life insurance policy owned by an ILIT are not subject to estate or gift taxes.

Control over distribution

An irrevocable life insurance trust (ILIT) is a powerful tool for estate planning and wealth management. It allows the grantor to have control over the distribution of their assets after their death, ensuring their wishes are met.

The grantor of an ILIT can dictate the terms, rules, and uses of the trust's assets with the consent of the trustee and beneficiary. This includes placing conditions on the distribution of assets to prevent misuse by beneficiaries. The trustee of an ILIT has discretionary powers to make distributions and control when beneficiaries receive the proceeds of the policy. The trustee can distribute the insurance proceeds immediately or according to specific milestones, such as graduating from college, buying a first home, or having a child.

The flexibility of ILITs enables individuals to achieve a variety of objectives, including wealth transfer, asset protection, and providing liquidity for estate taxes and other expenses. For example, the death benefit of a policy held in an ILIT can be used to cover an estate tax bill, preventing the forced sale of illiquid assets such as a family business, real estate, or private equity holdings.

The trustee of an ILIT ensures that the grantor's wishes are met and can provide guidance and oversight in administering the trust's assets. This feature is particularly useful when the grantor wants to protect younger family members from inheriting a large influx of wealth before they are ready.

In summary, an ILIT provides the grantor with control over the distribution of their assets, allowing them to dictate how and when beneficiaries receive their inheritance while also providing liquidity to meet various estate planning goals.

Frequently asked questions