We all don’t like talking about death. Unfortunately, it’s one dialogue that we can’t avoid forever. Sadly though, life insurance is -in most cases- an indispensable part of this dialogue. It’s all about taking out policies that protect our loved ones and our families by paying out if we die. There’s, however, one thing that a lot of people don’t know: these policies can be taxed after we die! What does this mean? Well, the money that you’ve worked so hard during your life to set aside to benefit your loved ones when you die could take a huge hit before they even see it! Fortunately, an Irrevocable Life Insurance Trust (ILIT) can give you a way around these draconian tax laws.
The primary purpose of ILIT is to hold a life insurance policy and the cash that’s needed to pay premiums on that policy. It has many amazing benefits chief among them; preventing your life insurance proceeds from being subject to estate tax. In other words, an ILIT can save your beneficiaries from paying hundreds of thousands or even millions of dollars in death taxes.
In this article, we’ll dive into the benefits of an ILIT and what it offers you.
Before we do that, if you are interested in an ILIT and live in California you should call us immediately. Click here to have us call you.
What is an ILIT?
An ILIT is more straightforward than most of us think. Like most trusts, ILIT is simply a holding device in the sense that it owns your life insurance policy for you. This, in turn, removes your life insurance from your estate, which means that it cannot fall victim to estate tax. As the name suggests, ILIT is irrevocable. This means that you can’t take the policy back in your name once you’ve created the trust and placed the insurance policy inside it
You can, however, still have some control over some facets of the ILIT. For instance, you can choose the beneficiaries of the insurance policy, outline the terms under which the proceeds will be distributed, and choose the trustee(s) who will manage the ILIT. It’s important to note that the many benefits of ILIT will only be achieved if it’s designed and managed properly.
How an ILIT Works
When you set up an ILIT, you become the grantor and can choose to place your life insurance policy in the trust. By doing this, the ILIT becomes the owner of your life insurance policy, and it is managed by a trustee (who need to be someone other than yourself). In normal cases, you can choose to pay premiums on life insurance through annual gifts. The idea here is that these annual gifts will not be subjected to gift tax if they’re $18,000 or less per beneficiary (according to the gifting rules in 2024).
At your death, the life insurance company will pay the death benefits, which should be income tax-free to the beneficiaries of the policy. Given that the policy was owned by the trust and not you as the grantor, the life insurance proceeds are not included in your estate and won’t be subjected to estate tax. As such, the ILIT ensures that death benefits from the life insurance policy are passed to the beneficiaries tax-free.
But there is a catch. In order for the irrevocable life insurance trust (ILIT) to be excluded from your estate the trust must have an independent trustee (so someone other than you and not someone you control). In addition, every time you pay the insurance premiums (usually done annually) you must give notice to the trust beneficiaries that a deposit was made into the irrevocable life insurance trust (ILIT) and giving them an unlimited, immediate right to withdraw those funds. The idea is that by not having control and by allowing the beneficiaries an immediate right of withdrawal, the IRS essentially treats the trust as if the trust beneficiaries purchased the policy. Therefore, it gets excluded form your estate.
This is an oversimplification, of course, but you get the idea.
Benefits of An Irrevocable Life Insurance Trust (ILIT)
Here are the amazing benefits of ILIT.
Provide Liquidity Promptly
There are generally some expenses that come when you die. For example, there are funeral expenses, administration expenses, debts, and estate taxes. In most cases, these expenses can be costly and may have a huge dent on your estate. Under such circumstances, an irrevocable life insurance trust can be used to promptly provide money to your beneficiaries after death.
Let’s be honest; disbursement of other benefits to the beneficiaries can take time with issues revolving around the will and such stuff. This may leave your beneficiaries in a bad financial state, especially if they were solely dependent on you. This is where the ILIT comes in handy. Life insurance proceeds are typically paid soon after your death and can be used to keep your beneficiaries afloat.
In essence, the proceeds of the life insurance can be used to maintain and support your beneficiaries, or educate your children in accordance with the terms you defined in the trust. This is because the ILIT creates liquidity without the delays that might be brought about by prolonged probate.
Avoid the Federal Estate Tax
This is perhaps the main benefit of ILIT; you can avoid the draconian estate tax that’s imposed on your estate at your death. The ILIT means that the life insurance proceeds are not included in your estate as they’re deemed a separate entity from your estate.
On the contrary, the benefits of the insurance policy will be deemed part of your estate if you own the policy at your death and may be subjected to a 40% estate tax if your estate exceeds the $13.61 million threshold. This will eat into the life insurance proceeds of your beneficiaries, and you certainly don’t want this.
That being said, ILIT can be a great way of minimizing the value of your estate, thereby avoiding or reducing the value of your estate that may be subjected to the draconian estate tax.
Avoid Gift Tax
As we noted earlier, it’s possible to pay premiums on your life insurance policy through contributions made to the trust in the form of gifts. As long as the annual gifts don’t exceed $18,000 per life insurance beneficiary, you can shelter these payments from gift tax. This is made possible by a special provision known as the Crummey power or clause. This provision stipulates that the beneficiaries with the Crummey power must be lawfully notified when the contributions are made to the trust but cannot withdraw the premiums.
ILIT isn’t Subject to Creditor’s Claims
In addition to estate planning, I also have a bankruptcy practice. One of the most difficult assets to deal with during a bankruptcy is life insurance. If you have a whole life policy, the entire cash value will be counted as an “asset” and the bankruptcy court will cash out the policy to pay your creditors.
Given that the ILIT isn’t considered part of your estate, the life insurance policy proceeds cannot be subject to creditors’ claims. Without this trust, your life insurance policy will be considered part of your estate upon your death and may be subject to creditors’ claims. This may, however, depend on various factors including local state law provisions. Therefore, if you are sued or have to go through a bankruptcy, the irrevocable life insurance trust (ILIT) protects this major asset ensuring hat it will always be there to protect your family even if everything else fails.
Simply put, an ILIT can be used to protect part of your assets from creditors, as well as against the financial carelessness of the beneficiaries themselves.
ILIT Offer Discretionary Powers to the Trust
While ILITs requires that you must give up all the rights of ownership by placing your policy in a trust that’s irrevocable, you -as the grantor- can have control over some aspects of the trust. For instance, you can stipulate when the amounts payable can be distributed to the beneficiaries.
Here’s a perfect example. You can withhold mandatory distributions until the beneficiary or beneficiaries reach a given age say, 25, 30, or even older. You should keep in mind that the beneficiaries will access these funds upon turning 18 if there’s no contrary stipulation. Again, you have the discretion to withhold the funds if the beneficiaries do not meet the specified requirements.
Conclusion
Life insurance is unquestionably one of the best ways to provide for your loved ones when you die. Unfortunately, the proceeds of your life insurance will be included in your estate if you still own the policy upon your death. This means that the proceeds will be subjected to the draconian estate tax if your estate’s value exceeds $11.4 million. This may eat into your beneficiaries’ death benefits and this is something that we all don’t want!
This is where the irrevocable life insurance trust comes in handy. It not only protects your life insurance policy from estate tax but also from creditors’ claims. An ILIT is also a great way of ensuring that your beneficiaries promptly access their benefits upon your death without having to wait for the lengthy probate processes.
You should, however, keep in mind that the success of the ILIT will largely depend on how it’s structured and managed. You should, therefore, consider hiring an experienced and professional estate planner to help you design and manage the ILIT properly.
For example, if you draft it wrong, or fail to give proper notice the entire life insurance policy could be counted in your estate resulting in significant taxes. That is why it is always a good idea to consult a lawyer first. If you live in California, contact us today to get started.
