Many different estate planning tools are available to individuals looking to save money for their loved ones upon their death, especially when it comes to avoiding estate taxes. The Irrevocable Life Insurance Trust or ILIT is one of those possible tools to a grantor’s disposal.
What Does ILIT Stand For?
The acronym ILIT stands for “Irrevocable life insurance trust.”
What is the Purpose of an ILIT?
An irrevocable life insurance trust (ILIT) is a special trust that benefits both the original owner and the beneficiary listed in a life insurance policy. Many financial planners utilize an ILIT as a way to protect large life insurance death benefits from being subject to estate taxes. In the U.S., an individual has the right to transfer property and other assets to beneficiaries upon his or her death. However, the government also has the right to tax that property after the individual’s death, which is where estate tax tables come into play. A certain amount of that property is exempt under federal estate tax exemptions, which currently is set at $11,180,000 for 2018. In addition, many individuals choose to utilize a revocable or irrevocable trust to avoid having to pay for estate taxes on their property after death. An ILIT can be utilized to exclude life insurance proceeds from estate tax, as well. An ILIT allows the individual to be both the owner and beneficiary of the life insurance policy, which essentially allows the money to fall under the protection of a trust, shielding it from estate tax.
How an ILIT Works:
To properly fund an irrevocable life insurance trust, federal estate tax law requires that the policyholder, the insured, must not have any type of ownership in the proceeds whatsoever. The grantor who creates the trust is normally also the insured, but he or she must completely relinquish control over the trust, which means the trust cannot be revocable. Under a revocable trust, the grantor has the right to change beneficiaries, move around property and revoke the trust. Therefore, the trust must be irrevocable, and the grantor cannot even serve as the initial trustee over the trust. The trust owns the insurance policy itself and pays the premiums to maintain the policy. To follow IRS guidelines, the ILIT must be set up at least three years before the grantor dies. If this time period is not met, the life insurance proceeds are included in the taxable estate. If the grantor pays cash to a trust that has been in existence for at least three years, and the trustee uses that cash to buy the insurance policy, however, this three-year rule does not apply to the life insurance policy.
Of course, the life insurance policy can always designate beneficiaries who will receive the money upon the death of the insured, but they do not have the ability to continue making payments on the policy or cannot cash out the policy, if it does have cash value, before the insured dies.
Can Life Insurance Be Paid to a Trust? Do You Put Life Insurance in a Trust?
Most estate planning attorneys will recommend that any asset that has a beneficiary designation, including retirement plans, IRAs and life insurance policies, should be changed to the trust to properly take advantage of the federal estate tax protection. After the death of the policyholder, if the life insurance beneficiary is the trust, the money then flows directly into the trust. However, if the life insurance policy value is less than the current federal estate tax exemption, it is possible that it can be left as a designation to a beneficiary, so long as the other assets do not add up to more than the exemption amount.
Can I Change the Beneficiary of an Irrevocable Trust?
One misconception people have is that beneficiaries cannot ever be changed under an irrevocable trust. While the term “irrevocable” does indicate that the creator of the trust cannot change or revoke it, the trust, if it is irrevocable, can be revoked or modified with the written consent of all current and future living beneficiaries. If the grantor and beneficiaries are interested in executing this type of document, however, an estate planning attorney should be consulted as the steps are specific and certain forms are needed to properly finalize this. If one of the beneficiaries does not consent, the trustee, beneficiaries and grantor must petition the court to have this completed.
How to Terminate an Irrevocable Life Insurance Trust
Similarly, an ILIT can be terminated upon either the consent of all current and future living beneficiaries, trustees and the grantor, or, if consent cannot be received by all, a petition can be made to court as to why the ILIT trust needs to be terminated. Upon hearing, the court can make a determination on whether the trust needs to be terminated.
What Are the Drawbacks to an ILIT?
One of the biggest complaints regarding an ILIT is once it is created, it can be hard to change. While, yes, the consent of the beneficiaries can be obtained, this process is not easy. Therefore, if the grantor creates the ILIT and then changes his or her mind on who should be a beneficiary, it can be quite difficult to change. Further, many individuals prefer the discretion and control that comes along with a revocable living trust because they still have control over the assets and who receives them. However, the estate tax benefits are not there as would be the case with an ILIT, so it is a give and take when it comes to deciding which option is best.
What Is an ILIT Crummey Trust?
A Crummey Trust, also known as an irrevocable gift trust, is another type of trust that allows a grantor to fund an irrevocable trust in a manner by which payments from it are treated as “gifts” of present interest to the trust beneficiaries. These gifts qualify them for the annual gift tax exclusion, and then the payments are used to pay premiums for the life insurance policy under the trust. The Crummey trust is named after a 1968 court case, Crummey v. Commissioner, and is meant as a way to allow wealthy grantors to pass property to their beneficiaries free of both the gift and estate taxes. The grantor makes a payment equal to whatever the annual gift tax exclusion amount would be, and this amount is calculated per beneficiary not per total gift. The beneficiaries are then allowed 30 days or so to withdraw the gift from the trust. If they keep it in the trust, that amount simply goes towards paying the life insurance policy. The right of the beneficiary to withdraw from the trust is known as a Crummey notice or notice of a Crummey withdrawal right, which must be given annually under IRS regulations.
Normally, Crummey trusts are created by wealthier parents to provide their children with continual, lifetime gifts while taking advantage of gift tax exclusions for their own tax benefits. For the 2018 tax year, this exclusion amount is $15,000 per gift made, meaning per individual. So long as the beneficiary is not a minor, he or she must be provided immediate access to the gift and must be given a specified period of time by which to make a withdrawal. After that time period, the normal trust provisions apply as to when the beneficiary gets the money, if the beneficiary does not make a withdrawal during that 30 to 60-day period of time.
What Decisions Must Be Made When Forming an ILIT?
An accountant who is experienced in trust and estate taxes should be able to first advise the grantor as to whether he or she would benefit from an ILIT. If the tax benefits are not worth the creation of the trust, a revocable trust or simply naming beneficiaries for the life insurance policy may be the best bet, depending on how much the payout is on the life insurance policy. Once someone decides to create an ILIT, several important decisions must be made, and a trust attorney can help the grantor(s) walk through the process. First, the grantor must select who will be the trustee of the trust. With a revocable trust, this is normally the grantor himself or herself, but with an ILIT, it needs to be a third party. It can be an individual or even a financial institution, if a trust department is available to handle the trust. Second, the beneficiaries of the life insurance proceeds must be named. Consider future beneficiaries as well, if the original beneficiaries predecease the grantor and make sure a succession plan is in place. Another decision that needs to be made is if a new life insurance policy needs to be purchased inside the trust, or if the grantor wishes to simply transfer an already-existing policy. Whatever decisions are made, it needs to be kept in mind that once the trust is in place, they are not easily changeable. Unlike a revocable trust, an ILIT has no flexibility. The grantor needs to live another three years after the policy is placed or transferred into the trust for the life insurance proceeds to pass outside of his or her estate and into the trust.
A Sample of an Irrevocable Life Insurance Trust
The following describes an average ILIT situation:
Samuel, age 65, wishes to create an irrevocable life insurance trust to ensure his or her children receive the proceeds of a life insurance policy purchased previously. This policy is for $1 million and is on Samuel’s life. Since he is of an age where he does not anticipate dying within three years of creating the trust, Samuel chooses to prepare an ILIT. He names his trusted financial advisor, John, to be his trustee of the ILIT. He names the beneficiary of the life insurance policy the “Samuel Irrevocable Life Insurance Trust,” and ensures that his two children, Kimberly and Jason, are the beneficiaries named in this trust. If either of them predeceases Samuel, their shares are equally divided amongst their then-living children. The trustee named is now responsible for managing and disposing of the life insurance proceeds per the trust terms drawn up by Samuel. If Samuel lives an additional five years and passes away suddenly, his $1 million life insurance policy is then transferred to his two children free of the federal estate tax. If he failed to live the three years after creating the irrevocable life insurance trust, the policy would go to the beneficiaries directly but would still pass free of the federal estate tax since the exemption would currently be more than what the children would receive. If his life insurance policy was for $25 million and the exemption amount for the year he died, if it was before three years since he created the trust, was $5 million, only the amount above the $5 million would be subject to the federal estate tax.
Contact an Attorney
Given the legal intricacies required with any type of trust document, especially an irrevocable life insurance trust, an estate planning attorney who regularly handles trust administration is recommended in preparing an ILIT. To properly accomplish the goals set out by the grantor, it is imperative that the proper decisions be made and that the document be written in the proper language and format to ensure that everything is executed correctly. Also, given the fact that an ILIT is not a flexible document and that once decisions are made and finalized, they are fairly written in stone, it is also recommended that an attorney discuss these options with the grantor and his or her family before signing on the dotted line. Other, less restrictive means may be available to him or her, and it is always recommended that all options be thoroughly explored. If an ILIT is the right option for the grantor, use the services of an attorney to prepare the forms and make sure everything is done according to legal standards and requirements.