One of the most common estate tax planning strategies is an Irrevocable Life Insurance Trust (ILIT). An ILIT is easy to understand and relatively easy to implement. In many situations it negates the need to incorporate other wealth transfer or estate tax reduction techniques.
ILITs can provide liquidity to an estate to help pay estate taxes, and can replace wealth lost to taxes. An ILIT also may provide assets for multiple beneficiaries with continuing professional management. But ILITs are not just a tool for the wealthy; they also may prove effective for those of more modest means.
The ILIT takes out a permanent life insurance policy on the life of the person who sets up the trust (the grantor). The ILIT is the owner and beneficiary of that policy. Typically, the grantor pays the premiums on the life insurance through annual gifts. If they are $13,000 or less per beneficiary per year and are paid according to trust documents, they have no gift tax consequences.
At the grantor’s death, the life insurance company pays a tax-free death benefit to the beneficiary of the policy. The grantor’s heirs are named the beneficiaries of the ILIT, which is how the life insurance policy proceeds pass to them.
The death benefit is not included in his or her estate for estate tax purposes. This means that all the death benefit passes to the heirs tax-free through the ILIT. Also, the trust can continue to hold money after the grantor’s death and manage it for the future benefit of heirs. The grantor may have selected investment strategies to manage the trust when creating it. An ILIT can be especially useful in providing for the future care of minor children and even unborn children. Professional management after the grantor’s death makes this doable.
ILIT documents should be custom designed, because the grantor must give up control to a third-party trustee. This can be either an experienced individual or a professional trust company. Specific instructions must be written in the document for the trustee to follow. This includes how life insurance proceeds will be managed after the grantor’s death, and whether the trustee has any power of discretion. ILITs are living documents, but there is little flexibility once they are created. Therefore the trust design process is crucial.
Two complexities with ILITs involve the three-year rule and the Crummey powers. Existing life insurance policies given to an ILIT must be held in the trust for at least three years for the death benefit to remain outside the estate. If the ILIT is the original applicant and owner of the policy, the three-year rule does not apply. Also, if the ILIT purchases the life insurance policy from the grantor, the three year rule does not apply. Crummey powers should be written into the trust document, if the annual premiums are to avoid gift tax consequence.
If you are considering establishing an ILIT, always speak to your trusted advisors. A Trusts & Estates attorney helps decide whether an ILIT is right for you. They will also help you draft your ILIT document, identify a capable trustee, and install the trust. A life insurance agent can review the various types of life insurance products that may be appropriate for funding your ILIT and help to coordinate the process. It’s important that you all work together to implement an ILIT.
In the right situation, there can be many benefits to an ILIT. Make sure you have the right team in place that understand your goals and are qualified to accomplish them.