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Irrevocable Life Insurance Trust FAQs

By Melissa A. Register November 5, 2018 Posted in Advanced Estate Planning

An irrevocable life insurance trust (ILIT) gives you more control over your insurance policies and the money that is paid from them. It also lets you reduce or even eliminate estate taxes, so more of your estate can go to your loved ones.

WHEN WOULD LIFE INSURANCE BE INCLUDED IN MY TAXABLE ESTATE?

Insurance policies in which you have any “incidents of ownership” are included in your taxable estate. This includes policies you can borrow against, assign or cancel, or for which you can revoke an assignment, or can name or change the beneficiary. You can imagine how life insurance can increase the size of your estate and the amount of estate taxes that must be paid.

HOW DOES AN ILIT REDUCE ESTATE TAXES?

The ILIT owns your insurance policies for you. Since you don’t personally own the insurance or have any incidents of ownership, it will not be included in your taxable estate — so your estate taxes are reduced. (There is a three-year rule for existing policies, which is explained later.) For an individual dying in 2018, a properly drafted and administered ILIT owning a life insurance policy with a $1 million death benefit could potentially save $400,000 in estate taxes.

HOW DOES AN ILIT WORK?

An ILIT has three components. The grantor is the person creating the trust — that’s you. The trustee you select manages the trust. And the trust beneficiaries you name will receive the trust assets after you die.

The trustee purchases an insurance policy, with you as the insured, and the trust as owner and (usually) beneficiary. When the insurance benefit is paid after your death, the trustee will collect the funds, make them available to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits), and then administer them for the trust beneficiaries as you have instructed.

WAIT, I THOUGHT THE ILIT POLICY PROCEEDS AREN’T SUBJECT TO ESTATE TAX?

That is correct, but for decedents with largely illiquid estates, the ILIT may purchase assets from the estate in order to inject liquidity to pay estate tax or other expenses. This is another ILIT benefit, particularly for closely held business owners.

CAN I BE MY OWN TRUSTEE?

Not if you want the tax advantages we’ve explained. Some people name their spouse and/or adult children as trustee(s), but often they don’t have enough time or experience. Many people choose a corporate trustee (bank or trust company) or co-trustee because they are experienced with these trusts. A corporate trustee will make sure the ILIT is properly administered and the insurance premiums are promptly paid.

WHY NOT JUST NAME SOMEONE ELSE AS OWNER OF MY INSURANCE POLICY?

If someone else, like your spouse or adult child, owns a policy on your life and dies first, the cash/termination value will be included in his/her taxable estate. That doesn’t help much. But, more importantly, if someone else owns the policy, you lose control. This person could change the beneficiary, take the cash value, or even cancel the policy, leaving you with no insurance. You may trust this person now, but you could have problems later on. The policy could even be garnished to help satisfy the other person’s creditors. An ILIT is safer; it lets you reduce estate taxes and keep control.

HOW DOES AN ILIT GIVE ME CONTROL?

With an ILIT, your trust owns the policy. The trustee you select must follow the instructions you put in your trust. And with your ILIT as beneficiary of the policies, you will even have more control over the proceeds.

For example, your ILIT could allow the trustee to use the proceeds to make a loan to or purchase assets from your estate or revocable living trust, providing cash to pay taxes and expenses. You could provide your spouse with lifetime income and keep the proceeds out of both of your estates. You could keep the money in the trust for years and have the trustee make distributions as needed to trust beneficiaries, which can include your children and grandchildren. Proceeds that stay in the trust can be protected from courts, creditors (even spouses) and irresponsible spending.

By contrast, if your spouse or children are beneficiaries of the policy, you will have no control over how the money is spent. If your spouse is beneficiary and you die first, all of the proceeds will be in your spouse’s taxable estate; that could create a tax problem. Also, your spouse (not you) will decide who will inherit any remaining money after he or she dies.

WHO CAN BE BENEFICIARIES OF AN ILIT?

You can name any person or organization you wish. Most people name their spouse, children and/or grandchildren.

WHERE DOES THE TRUSTEE GET THE MONEY TO PURCHASE A NEW INSURANCE POLICY?

Typically from you, but in a special way. If you transfer money directly to the trustee, there could be a gift tax or use of your lifetime estate/gift tax exemption. But in 2018, you can make annual tax-free gifts of up to $15,000 ($30,000 if your spouse joins you) to each beneficiary of the ILIT. (Amounts may increase periodically for inflation.) If you give more than this, the excess is applied to your estate/gift tax exemption.

Instead of making a gift directly to a beneficiary, you give it to the trustee for the benefit of each beneficiary. The trustee notifies each beneficiary that a gift has been received on his/her behalf and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds — by paying the premium on the insurance policy. Each beneficiary must understand the consequences of taking the gift now; for example, it may reduce the trustee’s ability to pay premiums.

ARE THERE ANY RESTRICTIONS ON TRANSFERRING MY EXISTING POLICIES TO AN INSURANCE TRUST?

Yes. If you die within three years of the date of the transfer, the insurance will be included in your taxable estate. There may also be a gift tax. Ideally, an ILIT is funded with a new life insurance policy. 

CAN I MAKE ANY CHANGES TO THE TRUST?

An ILIT is irrevocable, which generally means you cannot make changes to it. However, under the Uniform Trust Code (UTC) and decanting provisions in some states, you may be able to make some changes. Still, you should read the trust document carefully before you sign it.

SUMMARY OF BENEFITS OF A LIFE INSURANCE TRUST
Provides immediate cash to pay estate taxes and other expenses after death.
Reduces estate taxes by removing insurance from your estate.
Inexpensive way to pay estate taxes.
Proceeds avoid probate and are free from income and estate taxes.
Gives you maximum control over insurance policy and how proceeds are used.
Can provide income to spouse without insurance proceeds being included in spouse’s estate.
Prevents court from controlling insurance proceeds if beneficiary is incapacitated.

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