Irrevocable Life Insurance Trust: Complete Guide

Irrevocable Life Insurance Trust
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One way to ensure that your loved ones are taken care of financially and can benefit from your riches for generations to come is to establish a life insurance trust. Also, you get to decide when and how they get their hands on the money, which helps shield it from predators like creditors and poor investment choices. Furthermore, unlike asset transfers handled by probate courts after death, a trust keeps such disbursements private. In this article, we will discuss what an irrevocable life insurance trust is, how it works, its cost, and how to set it up.

What is an Irrevocable Life Insurance Trust?

An irrevocable life insurance trust (ILIT) is a legal arrangement used to manage life insurance proceeds for the benefit of beneficiaries while minimizing estate taxes. In an ILIT, the trust is the owner and beneficiary of a life insurance policy on the grantor’s life. The grantor transfers ownership of the policy to the trust, which means the policy is no longer considered part of the grantor’s estate upon their death. This helps reduce the estate tax liability. 

The trust specifies the beneficiaries who will receive the insurance proceeds after the grantor’s death. Once established, the terms of an ILIT generally cannot be altered without the consent of the beneficiaries, making it “irrevocable.” Wealthy people use ILITs to efficiently and tax-efficiently transfer life insurance payouts to heirs. Properly setting up an ILIT requires careful planning and the assistance of legal and financial professionals.

How an Irrevocable Life Insurance Trust (ILIT) Works

There are multiple participants in an irrevocable life insurance trust, including the grantor, trustees, and beneficiaries. The grantor normally establishes and finances the ILIT. The donor is permanently transferring assets to the ILIT and relinquishing all management authority to the trustee. The trustee manages the irrevocable life insurance trust, which makes distributions to the ILIT’s beneficiaries.

It is crucial for the grantor to prevent any incident ownership in the life insurance policy, and any premium payments should come from an ILIT-owned bank account.

There can also be gifting concerns if the policy being transferred has a substantial accrued monetary value. Have the grantor apply for coverage and include the owner as a trust to be designated if there is any doubt about the grantor’s capacity to obtain coverage and you want to verify insurability before spending the money to have a trust formed.

When a life insurance provider makes a proposal, the original application is dropped in favor of a new one that accurately identifies the trust as the policyholder. After that, the trust will receive the policy.

What is the Purpose of Creating an Irrevocable Life Insurance Trust?

Once an ILIT is set up and funded, it can be used for a variety of purposes.

#1. Help Heirs Reduce Their Tax Burden

The beneficiaries of your estate may benefit from an irrevocable life insurance trust if your net worth is substantial enough to trigger federal or state wealth transfer taxes. An ILIT’s life insurance death benefit is usually excluded from the insured’s federal taxable estate.

In most cases, the federal estate tax will not be due on the proceeds from a life insurance policy that has been transferred to an irrevocable life insurance trust more than three years before the insured’s death.

The federal estate tax rate is 40% on the part of an estate’s worth that exceeds the exemption amount of $1 million. Taxes range from 18% to 39% on the first $1,000,000 earned. A trust is a legitimate tool for avoiding these taxes and providing asset protection for loved ones and nonprofits.

#2. Distributions

The trustee of an irrevocable life insurance trust can have discretionary rights to make distributions and determine when beneficiaries get the proceeds of your policy. One or more of your beneficiaries can receive a lump-sum payment of the insurance payout right away. Alternatively, you can dictate when and how much money is given to beneficiaries.

The trustee may also be given the authority to make distributions to beneficiaries upon the occurrence of specified events, such as the completion of higher education, the purchase of a first house, or the birth of a child. The choice is ultimately yours. This can be helpful if the grantor of the trust has minor children or children who need financial protection, as well as in second marriages, to ensure how assets are allocated.     

#3. Legacy Planning

The generation-skipping transfer tax (GSTT) applies to gifts and transfers within a trust that go to or help people who are more than 37.5 years younger than the donor or who are younger than the donor by more than one generation. These gifts and transfers are taxed at a rate of 40%. 10

Grandparents are often given presents in place of their parents. It is possible to benefit from the grantor’s generation-skipping transfer (GST) tax exemption by purchasing life insurance with gifts to an ILIT.

Because the trust’s assets are not included in the grantor’s estate, the trust’s beneficiaries can include children, grandchildren, and even great-grandchildren without having to pay estate or GST tax on the trust’s earnings.

#4. Fiscal Considerations

There is a unique tax ID for irrevocable trusts and a steep income tax rate for these entities. However, both the death benefit and the cash value under a life insurance policy are not subject to taxation. As a result, there are no tax implications associated with having an irrevocable life insurance trust own the policy.

If an ILIT is set up correctly, the trustee can access the cash value while the insured is still alive by accepting loans and/or distributions at cost. If the trust’s assets continue to grow after a death benefit has been paid, the government may tax such gains rather than distribute them to the beneficiaries.

#5. Gift Tax Avoidance

Since the grantor’s contributions are deemed gifts to the beneficiaries, a correctly structured ILIT might prevent gift tax repercussions. The trustee must send a Crummey letter to each beneficiary of the trust informing them of their opportunity to withdraw a portion of the contributions for 30 days in order to avoid gift taxes.

The donations must sit with the trustee for 30 days before the premium can be paid using those funds. The Crummey letter qualifies the transfer for the annual gift tax exclusion by making the gift a present rather than future interest, thereby avoiding the requirement in most situations to file a gift tax return. 

Starting in 2022, you’ll have $16,000 (rising to $17,000 the following year) to distribute any way you see fit. All gifts combined totaled $16,000. A married couple can give an individual a combined $32,000 (rising to $34,000 in 2023) annually, tax-free. The number of gifts a couple can give to each other is unlimited.6

Gifts over $16,000 (rising to $17,000 in 2023) per year can be deducted against your lifetime estate tax exemption, which is $12.06 million in 2022 and $12.92 million in 2023.

What Is the 3-Year Rule for an Irrevocable Life Insurance Trust?

The “3-year rule” refers to a provision in the U.S. tax code that addresses gifts made to an irrevocable life insurance trust (ILIT). If the grantor of the ILIT transfers an existing life insurance policy into the trust and dies within three years of the transfer, the IRS includes the value of the life insurance policy in the grantor’s estate for estate tax purposes. This rule prevents individuals from avoiding estate taxes by transferring a life insurance policy to an ILIT shortly before their death.

By including the transferred policy’s value in the grantor’s estate, the IRS ensures that the policy’s proceeds are subject to estate taxes if the grantor passes away within the 3-year period. To avoid this, individuals typically establish the ILIT and wait for the 3-year period to pass before the policy’s coverage takes effect, ensuring that the proceeds are outside of their taxable estate. Proper planning and adherence to these rules are crucial to maximizing the benefits of an ILIT.

Who Can Be the Beneficiary of an Irrevocable Life Insurance Trust?

The beneficiaries of an irrevocable life insurance trust (ILIT) can be any individuals or entities designated by the grantor of the trust. Common beneficiaries include spouses, children, other family members, or charitable organizations. The choice of beneficiaries depends on the grantor’s preferences and financial planning goals.

Additionally, the flexibility of an ILIT allows the grantor to specify various conditions for the distribution of the insurance proceeds. For example, the grantor can outline that the funds are to be used for specific purposes, such as education or medical expenses, or set age-related milestones for the beneficiaries to receive the funds.

It’s important for the grantor to carefully consider their beneficiaries and clearly define their wishes in the trust document to ensure that the insurance proceeds are distributed according to their intentions. Consulting with legal and financial professionals experienced in estate planning can help in making informed decisions regarding the choice of beneficiaries and the terms of the ILIT.

What is an Example of an Irrevocable Life Insurance Trust?

Imagine Sarah, a wealthy individual who wants to ensure her children and grandchildren receive her life insurance proceeds without hefty estate taxes. She established an irrevocable life insurance trust (ILIT). Sarah transferred her life insurance policy into the ILIT, naming her children and grandchildren as beneficiaries.

Upon Sarah’s passing, the insurance proceeds are paid into the ILIT. The trust is designed to hold and manage these funds for the benefit of her heirs. The ILIT specifies that her children will get income from the trust and her grandchildren the principal after they die.

By creating the ILIT, Sarah ensures that the life insurance proceeds are not considered part of her taxable estate, potentially saving her heirs a significant amount in estate taxes. In addition to protecting the insurance benefits for future generations, the trust provides organized financial support for her family.

When to Use an Irrevocable Life Insurance Trust

Given these hurdles and probable pitfalls, the question becomes whether or not ILITs are ever worthwhile. A qualified yes is still the answer. Here are some examples of when an ILIT might be useful:

#1. You Run a Company

For those who have built a successful business, an irrevocable trust may be the best estate planning instrument available. You may not have enough cash to pay estate taxes if most of your wealth is in a company. Bruggeman warns that if this happens, your heirs may be forced to liquidate assets to pay the taxes. According to Radigan, beneficiaries can utilize the money from an ILIT’s distribution of a death benefit to pay their own estate taxes if the trust is set up to receive the death benefit tax-free.

#2. Alternative to stretching IRA

According to Hatfield, since the stretch IRA, which allowed non-spousal beneficiaries to stretch withdrawals of inherited assets over the beneficiary’s lifetime, is no longer an option, people who want to help their heirs with taxes owed on inherited individual retirement accounts can also use ILITs.

#3. You Have a High Net Worth

“Anyone with a net worth of more than $5 million who has permanent life insurance policies for a death benefit should consider an ILIT,” according to Gilbert. An insurance policy should not be placed in an ILIT if its primary purpose is to supplement retirement income.

How to Set up an Irrevocable Life Insurance Trust

You create an ILIT in several steps. The first is to go ahead and get a life insurance policy. The next step is to get some professional advice on what kind of policy and how much coverage you need, or to use our life insurance primer as a starting point. After determining your requirements, it’s time to begin researching life insurance providers.

Buying a life insurance policy is just the first step; next, you’ll need to establish an irrevocable life insurance trust. Choose a trustee who will handle the trust for the beneficiaries.

Now is the time to speak with a lawyer about creating an ILIT and get their advice on the trust agreement and any other applicable legal matters. You will keep paying the life insurance premiums after the trust is set up. Life insurance proceeds will be distributed from the trust rather than your estate after your death, reducing your taxable value.

What Is the Downside of an Irrevocable Life Insurance Trust?

Some disadvantages may arise from establishing an ILIT. Let’s look at three possibilities.

#1. The Inability to Make Changes to One’s Life Insurance Policy

The primary drawback of establishing an irrevocable life insurance trust is that the policy’s future ownership is transferred away from the policyholder. You won’t be able to adjust your coverage or beneficiaries. Your insurance will lapse if you don’t keep up with the payments, so that’s really your only option.

#2. Consequences of Gift Taxes

While setting up an ILIT may alleviate some tax obligations, it may also necessitate the payment of gift taxes. Your premium payments will be tax-deductible since your attorney will likely structure the ILIT agreement to benefit you. According to the Internal Revenue Service, there is currently a $17,000 per recipient annual gift tax exclusion.

However, if your annual policy premiums are more than $17,000, the government may require you to pay taxes on the excess. Since you’d need really lavish insurance to hit the limit, the chances of that happening are low. But it may happen, especially for the type of high-worth people who tend to favor ILITs.

#3. The Risk of Losing Coverage Due to Inability to Pay Premiums

It’s crucial to guarantee that you’ll always have the cash on hand to pay your premiums. The insurance company will cancel the insurance policy if premium payments for irrevocable life insurance trusts stop.

You should err on the side of caution and acquire cheaper coverage with fewer benefits if you are unsure about your ability to pay the premiums each month.

Irrevocable Life Insurance Trust Cost

The cost of setting up an irrevocable life insurance trust (ILIT) can vary based on several factors, including the complexity of the trust arrangement, the fees charged by legal and financial professionals involved, and any ongoing administrative costs.

Typically, establishing an ILIT involves legal fees for drafting the trust document and may also include fees for financial advisors or insurance professionals who assist with the transfer of the life insurance policy into the trust. These costs can vary based on the professionals’ hourly rates or flat fees.

Additionally, there might be ongoing administrative costs associated with managing the trust, such as trustee fees, accounting fees, and potential filing fees for required tax returns.

To understand ILIT setup and maintenance charges, consult legal and financial professionals. Establishing and operating the trust incurs fees, but the tax savings and benefits for your beneficiaries often outweigh them.

How to Fund an Irrevocable Life Insurance Trust

There are two ways to supply an irrevocable life insurance trust with funds. The first and most common option is to begin contributing to an ILIT before it has any assets. You can do that by giving the trust an amount equal to one year’s worth of life insurance premiums. In this case, if your premium is $10,000, you would give that amount to the trust so that the trustee could pay the premium when it’s due. After that, you give the trust the same amount of money every year.

You could set up something called a funded irrevocable life insurance trust instead of funding it every year. Giving an item that makes money to the trust and using the money it makes to pay your life insurance premiums is how this works.

One asset in an estate could be a rental property. Consider establishing a trust and using the rental income to pay for your standard life insurance premiums. While this asset-based strategy may be more practical for some grantors, it might raise significant tax concerns. Seek the advice of a tax professional before establishing a funded irrevocable life insurance trust.

Who is the Owner of an Irrevocable Life Insurance Trust?

The trust itself serves as the owner in the instance of an ILIT.  The trust will profit from the life insurance policy that is being applied for and owned.  Also, the insured party or parties are the grantor(s), and the ILIT is/are their beneficiary. The trustee must be a reliable person or entity, not the grantor(s).

The trust, not the policy owner, is the one who owns and pays for any life insurance policies that it holds. Typically, the donor funds the trust and the trustee uses the funds to pay the beneficiary’s life insurance premiums. 

The death benefit under an ILIT is not included in the insured person’s taxable estate. Insurance policies that fund ILIT assets belong to the trust, not your estate. This implies that the estate tax will not increase. 

In addition, an ILIT might be able to shield your heirs from creditors after you pass away and assist you in avoiding having to pay a large estate tax. But not everybody can make use of them. You are not allowed to make any modifications to the policy once it has been established. The trustee must approve any changes.

Why Not Have an Irrevocable Trust?: Bottom Line

While irrevocable life insurance trusts (ILITs) offer significant estate tax benefits, they may not be suitable for everyone. Setting up an ILIT involves relinquishing control over the trust assets, which can be a drawback for some individuals. Additionally, the process can be complex and may involve ongoing administrative responsibilities and costs. People with smaller estates may find the expenses associated with creating and maintaining an ILIT outweigh the potential tax savings.

Furthermore, individuals who have sufficient exemptions from estate taxes might not need an ILIT. It’s crucial to assess personal finances and consult professionals before choosing an ILIT.

Frequently Asked Question

What happens to an irrevocable trust when the grantor dies?

An irrevocable trust continues until the succeeding trustee distributes all trust assets after the grantor dies. If a minor inherits, the successor trustee will administer it in a sub-trust for the recipient.

Can you spend money from an irrevocable trust?

In an irrevocable trust, assets are permanently transferred. Creating a trust and transferring assets usually prevents their withdrawal. You can still be the trustee, but you can only withdraw money for necessary expenses.

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