Irrevocable Life Insurance Trust (ILIT)
An ILIT is a trust set up with the purpose of removing the ownership and proceeds of Life Insurance from a client’s estate to the trust. This way, at death, the death benefit is paid out to the trust which is removed from the client’s estate and not subject to estate taxation.
Purpose
Life insurance is a common tool used in planning for the transfer of wealth. The death benefit can cover costs and delays of the probate process, provide estate liquidity and survivor protection income tax-free. The value of the policy may be multiplied many times, as the death benefit could be substantially greater than the sum of premiums paid. For individuals already facing substantial estate tax liability, personally owned insurance used to cover estate settlement costs can worsen the tax burden. While life insurance proceeds are received income tax-free, they may be includable in the insured’s estate for estate tax purposes, and increase the ultimate amount subject to estate taxation. When combined with an ILIT however, life insurance can become an even more valuable estate planning tool.
Process
Death proceeds pass into the trust. Funds can be distributed income tax-free to the trust beneficiaries as directed in the trust document. By avoiding the insured’s estate, insurance proceeds in an ILIT do not increase the
decedent’s estate tax burden and avoid probate. This provides a source of funds to pay estate taxes from outside the estate. The trustee should be “allowed”, not “directed” to make loans or purchase estate assets. To “direct” would imply that the proceeds are held for the benefit of the estate, putting them back into the grantor’s estate – defeating the purpose of the trust. The grantor can neither change nor amend an ILIT and at death the insurance death benefit is paid to the trust.
Types of Insurance Trusts
ILITs May Be Funded Or Unfunded:
• Funded Insurance Trust: The trust owns income-producing assets such as securities, in addition to the life insurance policy. Income from these investment assets may be used to pay the insurance premiums, as well as buy insurance on the life of the grantor. This offers special advantages. When the grantor pays the income tax, they are, in effect, making an additional tax-free gift to the trust by allowing the assets inside the trust to grow income tax-free, providing greater assets for the beneficiaries.
• Unfunded Insurance Trust: The only asset owned by the trust is the life insurance policy. This results in the need to get dollars into the trust to pay the premiums on the policy. Gifts of premium dollars to the trust may be sheltered from gift tax by use of the annual tax exclusion, or lifetime exemption.
Advantages of Trust-Owned Life Insurance:
• If the policy is owned by a trust, the proceeds can pass to a designated beneficiaries’ income, estate-tax free and will not inflate the insured’s taxable estate.
• Life insurance proceeds paid to a trust avoid probate, reducing administration costs.
• Proceeds payable to the trust provide financial support for a surviving spouse or other beneficiaries.
• Trust language allows the grantor/insured to control how, when and to whom distributions are made. They may also permit the Trustee to distribute policy cash values to beneficiaries in specified circumstances.
• Second-to-die life insurance policies in conjunction with an ILIT may be ideal for clients who are married.
Avoiding the “Three-Year Rule”
The value of a gifted asset made within three years of their death will be included in the original owner’s gross estate. Provisions can be made in the trust document to distribute the proceeds to the surviving spouse if the three-year rule is triggered, thus qualifying them for the unlimited marital deduction and avoiding federal estate tax at the insured’s death.
There are ways to avoid the three-year rule problem; one is by using a new policy. If a new policy is used, the trust should be
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