If you are starting your estate planning process, an ILIT (Irrevocable Life Insurance Trust) will provide peace of mind. If you have young beneficiaries or a large estate, the trust will be able to provide control over the life insurance policy.
The irrevocable aspect of a trust ensures that the creator or grantor will not be able to change it once it is established. The ILIT is primarily used as an estate planning and financial planning tool to protect assets subject to high estate taxes.
What do you need to know about an irrevocable life insurance trust?
A revocable trust enables the grantor to make changes to the trust. If you want, you can even end the trust. An irrevocable trust will not allow any changes once it is setup. Only the beneficiaries will be able to change the trust.
Revocable trusts are more common because they provide flexibility to the trust maker. An irrevocable life insurance trust is a good idea if you want to save taxes.
A grantor will set up the irrevocable trust and fund it. The transfers and gifts are then passed on to the trust. Transfers and gifts are permanent. Changes in the trust and its funds are not permitted after establishment.
The trustee manages the trust. The distribution made to the beneficiaries is also managed by the trustee. The trustee who manages the trust is separate from the grantor.
benefits of an irrevocable life insurance trust
- lower estate tax
The death benefits will not form part of the gross estate when you opt for an irrevocable trust. This means that the benefits are not subject to federal and state estate tax.
The trust will also be able to cover the cost of the loan and property taxes when the property is purchased. The grantor will not be able to make purchases because the property is now part of the trust.
It is important to know that even though the estate is exempt from estate taxes, the beneficiary’s estate will be subject to such taxes. The burden of tax falls on the beneficiaries.
When ILIT is structured in the right way, it helps in providing liquidity. This will help pay property taxes and other expenses and debts. This is done through a loan or purchasing property from the grantor’s estate.
Lifetime gifts will help reduce the taxable estate. This is done by transferring assets into an irrevocable life insurance trust.
- protect assets from creditors
An irrevocable trust will be able to protect you from some legal proceedings. Protect assets from creditors by setting up a trust.
Creditors will, however, be able to attach distributions made from the ILIT.
- avoid gift tax
Contributions made by the grantor to the beneficiaries are considered gifts. If you want to avoid gift taxes, it is important that the trustee inform the beneficiaries of their right of withdrawal.
The letter informs the beneficiaries of their right of withdrawal for a period of 30 days.
After a period of 30 days, the trustee will be able to pay the life insurance premium using the contributions.
The transfer can be excluded for annual gift tax because the letter makes the gift present rather than future interest. This helps avoid the need to file a gift tax return.
- Leaving Property to Minors and Securing Liability
Minors are not prepared to handle large amounts of money and property. An irrevocable trust will allow you to put restrictions in place to protect the assets.
Restrictions may be placed such as beneficiaries reaching a certain age to gain access to the assets. The creation of a trust will help ensure responsible behavior from adults or minors with reckless spending habits.
The trust is overseen by an appointed trustee. The property will be distributed according to the wishes of the grantor. It provides asset protection for the beneficiaries.
As ILITs are not owned by the beneficiaries, the assets are protected even if there is future litigation involving the beneficiaries.
Linking assets to beneficiaries is difficult. This prevents creditors from accessing the property.
- government benefits
Trust beneficiaries receiving government assistance (Medicaid or Social Security Disability Income) are protected by the proceeds from life insurance policies purchased by the ILIT.
Trustees will be able to control how trust distributions are used. This is done carefully so that it does not hinder the right of the beneficiary to receive government assistance.
- legacy plan
The generation-skipping transfer tax sets a 40% tax on transfers and gifts in trusts. The tax also applies when gifts or transfers are made from the donor to unrelated persons under the age of 37.5.
Related persons who are at least one generation younger than the donor will also be covered as per the tax provisions. A common example is gifting property to grandchildren in lieu of children.
The ILIT will help the grantee take advantage of the generation skipping transfer tax exemption. Gifts made to the trust are used to fund and purchase insurance policies.
As death benefit income is excluded from the grantor’s estate, multiple generations of the family (children, grandchildren, and great-grandchildren) will be able to benefit from the trust’s assets.
downsides to an irrevocable life insurance trust
There are certain tax benefits that apply only if the grantor survives three or more years after the insurance policy is transferred to the trust. If the term is less than the specified term, the IRS will begin including the insurance income.
When ILIT buys the insurance policy, you will be able to avoid the specified three year period. Funds will have to be given to the trust to pay the premium.
When you give away trust money to a policy, it becomes subject to gift tax. Gift taxes can be avoided if letters are sent to the beneficiaries informing them that the money is not immediately accessible to them.
The biggest downside of ILIT is that it cannot be changed once it is set up. You have to give up complete control of the property. Further, dissolution of the trust is not possible until the payment of premium is stopped.
When the beneficiaries receive the property, they will have to pay large taxes.
How to setup an ILIT?
Setting up an ILIT is a complicated process. Begin the process by selecting an attorney who specializes in estate planning.
You need to make the following decisions before drafting the trust document:
Who will be the trustee of ILIT?
Who will be the beneficiary or beneficiaries of the proceeds of the insurance?
Are you transferring an existing policy to a trust or buying a new life insurance policy?
Before taking these important decisions, it is advisable to give them a lot of thought. You will not be able to change any of these decisions once you set up an irrevocable trust.
ILIT is named as the beneficiary of the life insurance policy. This means that in the event of your death, the payment will go directly to ILIT.
Beneficiaries will receive the benefits without paying any wealth or income tax. Fund the trust for the payment of premiums. This ensures that the insurance policy does not lapse.
Who are the beneficiaries of an ILIT?
The primary beneficiary of the insurance policy is the ILIT. The death benefit is transferred to ILIT. These profits are held in trust for the benefit of the beneficiaries named in the trust documents.
If the trust’s income is held for the benefit of a spouse, regular incremental payments are received instead of a lump sum. Incremental payments are not taxed.
What are events of ownership?
If the insurance policy is owned and held by you, you will be able to change beneficiaries or withdraw the cash value at any time. This means that the tax authorities will include the proceeds of the insurance policy while calculating the property value.
This will make the property more susceptible to property taxes if the income is higher. This is possible when the asset is the beneficiary of the policy.
The policy will be property of the estate if it is owned at the time of death and even if children, grandchildren or great-grandchildren or anyone else is named as the beneficiary.
How to dissolve an ILIT?
Once an irrevocable trust is established, it cannot be undone. Premiums have to be paid to keep the insurance policy in force. If you want to dissolve the trust, all you have to do is stop paying premiums.
The insurance policy will lapse if the premium is not paid.
An irrevocable life insurance trust is a good idea if you have significant assets and money and want to protect them after you die. This will also help in avoiding creditors and high property tax.
You need to remember that ILIT may not be suitable for everyone. After you set up a trust, you won’t be able to make any changes to it. Only the beneficiaries of the trust will be able to approve any changes to the trust.