If you are just beginning your estate planning process, an ILIT (irrevocable life insurance trust) will give you peace of mind. If you have young beneficiaries or significant wealth, the trust may provide control over a life insurance policy.
The irrevocable aspect of the trust ensures that the creator or grantor will not be able to change it after it has been established. ILIT is primarily used as a financial and estate planning tool to protect assets subject to high estate taxes.
What do you need to know about an irrevocable life insurance trust?
A revocable trust allows the grantor to make changes to the trust. You may also terminate the trust if you wish. An irrevocable trust will not allow changes to be made after it is set up. Only the beneficiaries will be able to change the trust.
Revocable trusts are more common as they offer flexibility to the trust creator. An irrevocable life insurance trust is a good idea if you want to save taxes.
A grantor will establish the irrevocable trust and fund it. Transfers and gifts are then made to the trust. Transfers and gifts are permanent. Changes to the trust and its funds after incorporation are not permitted.
The trustee manages the trust. Distributions made to beneficiaries are also administered by the trustee. The trustee who manages the trust is different from the grantor.
Benefits of an irrevocable life insurance trust
- Lower wealth tax
Death benefits will not be part of the gross estate when you opt for an irrevocable trust. This means that the benefits are not subject to state and federal estate taxes.
The trust will also be able to cover debts and estate tax costs when the estate makes purchases. The grantor will not be able to make the purchases as the estate is now part of the trust.
It is important to know that although the estate is exempt from estate taxes, the beneficiary’s estate will be subject to such taxes. The tax burden is transferred to the beneficiaries.
When ILIT is drafted correctly, it helps provide liquidity. This will help pay estate taxes and other expenses and debts. It is done through a loan or by buying assets from the grantor’s estate.
Lifetime gifts will help reduce taxable estate. This is done by transferring assets to an irrevocable life insurance trust.
- Protect assets from creditors
An irrevocable trust may protect you from certain legal proceedings. Protect assets from creditors by creating the trust.
Creditors, however, may garnish distributions made from ILIT.
- Avoid gift taxes
Donations are considered contributions from the grantor to the beneficiaries. If you want to avoid gift taxes, it is important that the trustee notify the beneficiaries of the right to withdraw.
The letter notifies beneficiaries of the right to withdraw for a period of 30 days.
After the 30-day period, the trustee will be able to pay the life insurance premium with the contributions.
The annual gift tax rollover can be excluded since the letter makes the gift a present rather than future interest. This helps to avoid the need to file a gift tax return.
- Leaving assets to minors and guaranteeing responsibility
Minors are not equipped to handle large amounts of money and property. An irrevocable trust will allow you to set restrictions to protect assets.
Restrictions can be set such as beneficiaries reaching a certain age to access the assets. Creating a trust will help ensure responsible behavior by adults or minors with reckless spending habits.
The trust is overseen by an appointed trustee. The assets will be distributed at the will of the grantor. This provides asset protection for the beneficiaries.
Since ILITs are not owned by the beneficiaries, the assets are protected even if there is future litigation involving the beneficiaries.
Linking the assets to the beneficiary is difficult. This prevents creditors from accessing the assets.
- government benefits
Beneficiaries of trusts that receive government assistance (Medicaid or Social Security Disability Income) are protected with proceeds received from a life insurance policy purchased by an ILIT.
The administrator will be able to control how trusted distributions are used. This is done carefully so that it does not obstruct the beneficiary’s right to receive government assistance.
- legacy planning
The generational leap transfer tax stipulates a 40% tax on transfers and donations in trust. The tax is also applicable when the donation or transfer is made to persons other than the donor who are more than 37.5 years younger.
Related persons who are at least one generation younger than the donor will also be covered under the tax provisions. Donors gifting assets to grandchildren rather than children is a common example.
ILIT will assist the grantor in taking advantage of the generation skip transfer tax exemption. Gifts to the trust are used to finance and purchase the insurance policy.
Because death benefits are excluded from the grantor’s estate, multiple generations of the family (children, grandchildren, and great-grandchildren) will be able to benefit from the trust assets.
Disadvantages of an irrevocable life insurance trust
- There are certain tax benefits that become applicable only when the settlor lives three or more years after transferring the insurance policy to the trust. The IRS will begin to include insurance proceeds if the period is less than specified.
When ILIT buys the insurance policy, you will be able to avoid a period of three years that is specified. The trust will have to finance to pay the premiums.
- When you give trust money to a policy, it becomes subject to gift tax. Gift taxes can be avoided by sending letters to recipients notifying them that they cannot immediately access the money.
- The biggest drawback to ILIT is that it cannot be changed once set. You will have to enjoy full control of the assets. Apart from this, the dissolution of the trust is not possible unless premium payments are not stopped.
- When the beneficiaries receive the inheritance, they will have to pay considerable taxes.
How to set up an ILIT?
Setting up an ILIT is a complex process. Start the process by selecting an attorney specializing in estate planning.
Before drafting the trust document, you will need to make the following decisions:
- Who will be the trustee of ILIT?
- Who will be the beneficiary or beneficiaries of the insurance product?
- Will you be transferring an existing policy to the trust or purchasing a new life insurance policy?
Before making these important decisions, it is advisable to give them a lot of thought. You will not be able to change any of these decisions after you establish an irrevocable trust.
ILIT is named as the beneficiary of the life insurance policy. This means that the payment will go directly to the ILIT in the event of your death.
Beneficiaries will receive benefits without paying any estate or income tax. Finance the trust for the payment of premiums. This ensures that the insurance policy does not lapse.
Who are the beneficiaries of an ILIT?
The primary beneficiary of the insurance policy is ILIT. Death benefits are transferred to ILIT. These benefits are held in trust for the benefit of the beneficiaries named in the trust documents.
If the trust proceeds are held for the benefit of the spouse, regular incremental payments are received instead of a lump sum. Incremental payments are not taxed.
What are property incidents?
If you own and keep the insurance policy, you can change beneficiaries or withdraw the cash value at any time. This means that the tax authorities will include the proceeds from the insurance policy when calculating the estate value.
If the income is high, it will make the estate susceptible to estate taxes. This is possible when the estate is the beneficiary of the policy.
The policy will be an estate asset if it is owned at the time of death and even if children, grandchildren or great-grandchildren, or another person are named as beneficiary.
How to dissolve an ILIT?
Once an irrevocable trust is established, it cannot be undone. Premiums must be paid to keep the insurance policy in force. If you want to dissolve the trust, all you have to do is stop premium payments.
The insurance policy will lapse if the premiums are not paid.
Conclusion
An irrevocable life insurance trust is a good idea if you have a significant amount of assets and estate and want to protect them after your death. This will also help avoid creditors and high estate taxes.
You should remember that ILIT may not be right for everyone. After setting up the trust, you will not be able to make any changes to it. Only the beneficiaries of the trust will be able to approve any changes to the trust.