May 20

The Irrevocable Life Insurance Trust (ILIT): An Excellent Way to Avoid a Hefty Estate Tax for Your Heirs

You purchased a life insurance policy to provide for your family after you die, and you have peace of mind thinking they’re protected. But you may be surprised—and not at all happy—to learn that the proceeds from that life insurance policy may be included in your estate.

Though the federal estate tax threshold is currently a rich $11.58 million per estate, $7 million in assets will combine with an almost $7 million policy to cause a hefty tax bill for your heirs.

Plus, that federal estate tax exemption is set to expire at the end of 2025, and who knows if changes in Washington could cause it to sunset sooner. Even scarier, many states impose their own estate taxes at much lower thresholds (e.g., $1M or lower), so smaller estates could be subject to substantial taxation, too.

A Workaround for Tax Savings—Massive and Otherwise

The good news is there are workarounds, and an excellent one is an irrevocable life insurance trust (ILIT), a trust that is formed to own a life insurance policy. Essentially, the ILIT takes ownership of your insurance policy, and the trust is designated as the policy’s primary beneficiary. When you die, death benefits are deposited into the ILIT and held in trust for the benefit of the individuals you’ve named in your trust document to receive the money. For large estates, this can result in massive tax savings for your heirs, and if you live in a state with lower tax minimums, forming an ILIT offers benefits, too.

Even More Pluses

The trust can either purchase a policy directly or, if you already have a policy, you can transfer that policy into the ILIT.  What’s more, the ILIT has benefits even beyond the estate tax savings for your heirs. These include:

Control: Trusts are highly customizable and have the capability to give you, via your trustee, precise control over how proceeds are paid out. It will allow you to control, when, how, and why your beneficiaries receive the proceeds of your policy. This is not the case if you have a life insurance policy that simply pays a lump sum to non-trust beneficiaries, providing them with a windfall that places it at the risk of being mismanaged.

Protection from creditors: Like other irrevocable trusts, ILITs also offer excellent protection from creditors for the money you’ve invested in life insurance.  For example, if a grantor sets up an ILIT to make distributions to his son, a compulsive gambler, and the son falls into debt, his creditors cannot reach the life insurance payout while it’s in the trust.

Medicaid Eligibility: As long as the premiums for the policy have been fully paid, the ILIT eliminates the value of the policy being counted against you or your spouse should you need Medicaid to pay for long-term care.

Gift Tax Exclusion: The ILIT trustee takes money you contribute to the trust and uses it to pay your life insurance premiums to the insurance company. These transfers are covered by your gift tax exclusion, provided your trustee sends a document called a “Crummey” letter to each beneficiary each time you transfer money to the trust. This letter advises your beneficiaries that they can ask for their portion of the money within a specific period of time, usually 60 to 90 days. As long as for all intents and purposes they have an immediate right to the money, the gift tax doesn’t apply. A fringe benefit: Because the premiums are negligible when compared with the policy proceeds, your beneficiaries will likely be incentivized to allow the policy to continue uninterrupted within the trust—giving you the confidence that your legacy will be carried out.

Flexibility: You can add features to the ILIT that will allow the trust to fund specific needs such as ILIT distributions for a beneficiary who needs money for college tuition, down payment for a home, starting a business, getting married, having a baby, etc.

With the Good, Some Limitations

The ILIT does come with some conditions: The trust is irrevocable, which means that once you fund the ILIT with the life insurance policy, you can’t rethink your decision and take the policy back or out at a later date. That said, discontinuing your payment of premiums will cause your policy to lapse and leave the trust an empty shell.

You also give up any rights to control or modify the trust, and you cannot serve as the trustee.  You can, however, name your spouse, your adult children, a financial institution, or anyone else you trust to serve as trustee.  Net-net, even with the conditions imposed by the ILIT and your compliance with these conditions, the substantial payout from the policy goes to the ILIT and is, consequently, excluded from your estate.  The benefits are held in trust for the benefit of your named trust beneficiaries. For example, if you named your spouse as a beneficiary of the ILIT, your spouse would receive regular incremental payments as defined in the trust when you die. Without an ILIT, your spouse would receive the proceeds in a lump sum. Upon your spouse’s death, any remaining death benefits would be included as part of that estate and would be taxed accordingly. With an ILIT, you can avoid this outcome.

Proceed With Caution: ILIT's Are Sophisticated and Complex

Still, despite the many benefits, you must take precaution when you set up the trust. ILITs are sophisticated and complicated estate planning vehicles. Failing to structure them properly can negate the tax and other advantages. Plus, your unique circumstances and family needs dictate the type of insurance policy you should use to fund the trust and other features and conditions of the trust as well. It’s wise, therefore, to seek guidance from your estate planning attorney, financial planner and CPA to set up and administer the trust.

Timing Is Imperative

Also, time is of the essence. If you decide you want to pursue this option, don’t delay in setting up your trust—for example, until you’re ill or elderly. The IRS has attached a three-year lookback period to the ILIT. If you die within three years of transferring your life insurance policy to the trust, the IRS will still include the policy proceeds for estate tax purposes within your estate.

Consulting with your financial advisor, CPA, and estate planning attorney is a must to make certain the ILIT is set up and administered properly.

At GARZA we understand the complexity and risk involved with estate planning and structuring and know that careful planning is key to protecting your estate. Our knowledge of tax law keeps us ahead of changes in the financial environment, enabling us to help you maximize the use of your assets for you and your heirs.

Call us at  208.557.8705 and learn how an ILIT and/or other estate planning tools can reduce your estate tax liability and truly give you peace of mind, knowing you are leaving the legacy you’ve intended for your spouse, your children, and the future generations of your family.

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