If you have family members who depend on you, you know you should have life insurance. But should you have a life insurance trust? Most people don't, but more people should.
What is a life insurance trust? An irrevocable life insurance trust (ILIT) is a trust that is established for the ownership and control of a life insurance policy, whether whole-life or term. In order for an ILIT to be effective, the settlor or grantor of the trust (usually the person whose life is insured by the policy held in trust) may not have any "incidents of ownership" in the policy.
As the name suggests, the trust cannot be revoked, meaning the insured person is no longer the owner of the policy. The ILIT manages anything to do with the policy during the insured's lifetime, and manages and distributes benefits paid out upon the insured's death. An ILIT may contain an individual policy, or a "second-to-die" policy which pays out when the second person in a couple dies.
You may be among the people who should consider an ILIT if any of the following apply to you:
An ILIT can be drafted to avoid gift taxes if it is set up like a Crummey trust. The settlor contributes funds to the ILIT. The trustee notifies the beneficiaries of the trust that they have the right to withdraw, for a period of thirty days, a portion of the contribution. After that thirty day period expires, the trustee is free to use the contribution to pay the premium on the life insurance policy.
This process qualifies the funds contributed to the ILIT for the annual gift tax exclusion, because the ability of beneficiaries to access the funds during the thirty days makes the contribution a present interest.
Placing a large life insurance policy in an ILIT is also an effective way to avoid state and federal estate taxes. If you are the owner of a life insurance policy in your name, the proceeds payable at your death will be considered part of your estate. If the proceeds are significant, your estate could be subject to state or federal estate tax. When the ILIT owns the policy, and you retain no incidents of ownership, the death benefit is no longer included in your estate.
If your estate is still subject to tax, proceeds from the life insurance policy can be used to pay those taxes, rather than your executor potentially having to liquidate other assets to do so. Furthermore, when you transfer funds into the ILIT during your lifetime, that also reduces the size of your taxable estate.
If you are the settlor of an ILIT, as discussed above, you have given up your incidents of ownership in the life insurance policy and any other assets in the trust. As such, those assets should be out of the reach of your spouse in the event of a divorce or from other unforeseen creditors. Unlike other types of trusts, an ILIT can include a provision terminating a spouse's interest under certain circumstances.
If you had no other reason to establish an ILIT, protecting assets from a spouse or creditor may not make the trouble and expense worth it. There are other asset protection tools. However, if you are interested in an ILIT for other reasons, asset protection could be an added benefit.
If one of the named beneficiaries of the ILIT receives, or is likely to receive, government benefits such as Medicaid, the trustee can structure distributions from the trust so as not to jeopardize that beneficiary's means-tested ability to receive benefits. If, by contrast, there was no ILIT, and the individual was just a beneficiary of your life insurance policy, the sudden influx of cash when the death benefit is paid could cause that person to lose eligibility for government benefits. If the beneficiary received Medicaid in order to pay for nursing home care, for example, they might lose access to those payments and be compelled to spend down the policy proceeds in order to again become eligible for Medicaid. An ILIT avoids this outcome.
When you have a life insurance policy, at your death, the proceeds are paid to your named beneficiary or beneficiaries. If you think it would make more sense for your beneficiaries to receive distributions in other than a lump sum, an ILIT is an excellent way to achieve that.
With an ILIT, you set the terms when creating the trust document. You can arrange for an immediate lump-sum distribution; distribution to beneficiaries contingent on achievement of certain milestones, such as graduation from college, marriage, or birth of a child; regular distributions at regular intervals—it all depends on what your goals are.
It is generally ideal to establish an ILIT before purchasing the life insurance policy it will contain, so that the insured need never have ownership of the policy. But whether you have a policy that you may want to transfer into an ILIT, or are contemplating creating an ILIT to purchase and hold a policy, you should explore your options with an experienced estate planning attorney to make sure an ILIT is the best choice for your needs.
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