Irrevocable Life Insurance Trusts

Life insurance proceeds are paid out to beneficiaries tax free upon an insured’s death. However, the proceeds are included in calculating the value of the decedent’s estate. While many clients believe their estates are not significant enough to worry about tax planning, one large life insurance policy can cause his or her estate to become taxable. An Irrevocable Life Insurance Trust (“ILIT”) is a tool for some individuals to successfully reduce their estate tax bill.

The basic ILIT is a trust that owns a life insurance policy on an individual who neither maintains control of the insurance policy nor is the trustee of the trust. Since the insured relinquishes control of the policy and trust, the proceeds of the policy are excluded from the insured’s estate once he or she dies. An ILIT is not for everyone. Like most things it has advantages and disadvantages to weigh to determine if an ILIT is an appropriate planning tool for your estate.

Advantages

The benefit of life insurance, in general, is to guarantee surviving family members are cared for. The most significant advantage of an ILIT is the potential tax savings. As we often mention, spouses can pass an unlimited amount of assets to one another upon death without exposure to estate taxes.  However, upon the death of the second spouse, the assets are then open to potential estate taxes.  An ILIT can reduce the overall tax liability for a couple’s estate.

An ILIT can retain the proceeds of the life insurance policy in trust if the beneficiaries are minor children or if it is beneficial for the proceeds to remain in trust for other reasons. While the insured cannot be the trustee of an ILIT, the insured can maintain a limited power to remove or replace the trustee of the ILIT pursuant to certain restrictions.

Disadvantages

A disadvantage to the ILIT is that the insured does not retain control or ownership over the policy and trust, and cannot amend or revoke the trust. Another disadvantage of an ILIT is that the life insurance policy is usually more expensive and there is additional expense to establish the trust (but often the potential tax savings greatly outweigh the costs). The ongoing maintenance of the ILIT can be complicated and the insured must appoint someone they trust and who is knowledgeable enough to be the trustee.

If an existing life insurance policy is transferred into an ILIT, the insured/transferor must survive for at least 3 years from the date of transfer to make certain the proceeds are not included in his or her estate. However, if the life insurance policy is purchased concurrently with the establishment of the ILIT then there is no need to be concerned about the 3-year rule.

If you think an ILIT would be beneficial to your estate plan, be sure to contact one of your professional advisors – attorney, financial advisor, and/or tax planner – to discuss the specifics of your estate and determine if it is right for you.