What's an Irrevocable Life Insurance Trust and Why Do I Need One?

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Much of estate planning centers on avoiding what can be draconian taxes, and life insurance is a danger area for estate planners. If you own a life insurance policy in your own name, then the proceeds are included in your estate and potentially subject to tax of up to 40%. By using an irrevocable life insurance trust, or ILIT, to hold title to your life insurance policy, you can avoid having the death benefit included as an estate asset, saving your heirs hundreds of thousands or even millions of dollars in taxes. Setting up an ILIT takes complex planning, but it can be worth it in many cases.

What an irrevocable life insurance trust looks like

An ILIT is a trust whose primary purpose is to hold a life insurance policy and the cash needed to pay premiums on that policy. To set up an ILIT, you initially fund the trust with money to pay initial premiums, and then the trust purchases the life insurance policy naming you as the insured.

The key to success with an ILIT is that the trust must be structured in such a way that it avoids giving you what are known as incidents of ownership. If you have the right to borrow against the policy, change beneficiaries, or change how proceeds are distributed from the trust, then you'll have incidents of ownership in the policy. That will result in the death benefit being included in your estate and subject to estate taxes.

Typically, the ILIT pays ongoing premiums by receiving future gifts from the person who set up the trust. Most of those using this strategy take advantage of the annual gift tax exclusion of $14,000 per recipient, drafting special provisions into the ILIT to allow it to be treated as if beneficiaries had the right to a present interest in the trust.

After your death, the other provisions of the trust kick in. ILITs often resemble traditional trusts in this respect, setting limitations on the rights of certain beneficiaries to receive trust assets or establishing guidelines under which beneficiaries can make requests for financial distributions. The named trustee manages the assets and ensures that they are invested appropriately to meet the future needs of the beneficiaries. Once all the protective terms of the ILIT are met, the trust can terminate and make final distributions to its recipients.

Why ILITs are helpful

The biggest benefit of the ILIT is that the proceeds of the life insurance policy escape taxation. Given that the estate tax bill on a $1 million policy can be as much as $400,000, the savings from using sophisticated strategies like irrevocable life insurance trusts usually justify the expense of having estate planning professionals set up an ILIT on your behalf.

Currently, the vast majority of people fall well short of the $5.45 million exemption against the estate tax, even if they have fairly valuable insurance policies in their name. Nevertheless, there's always the potential of adverse legal changes in the future, and good planning now can protect you from future trouble in ways that you might not be able to duplicate if you wait.

Dangers of irrevocable life insurance trusts

As useful as they can be, ILITs sometimes create problems. The most common issue is when the cost of continuing the life insurance policy becomes prohibitively high, making ongoing funding of the trust a financial difficulty. Such situations can leave the ILIT trustee in a tough situation, requiring consideration of options like borrowing against the policy value or even surrendering the policy entirely. It can also leave beneficiaries fighting against the trustee, who will often be one of the family members involved in the trust.

The other question arises in considering various types of life insurance policies at the outset. Historically, many assumed that the selection of the policy by the person creating the ILIT was sufficient to give the trustee legal cover. However, liability concerns now have some ILIT trustees needing to look closely at alternatives to ensure that the selected policy is the best available to meet the purposes of the trust.

Despite these complications, the potential to save hundreds of thousands or even millions of dollars in estate tax liability makes irrevocable life insurance trusts well worth the effort. By working closely with an estate planning attorney, trust company, and other professionals, you can ensure that your ILIT meets both your needs and the needs of your family.

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