An irrevocable life insurance trust (ILIT) is a trust established to own a life insurance policy on the life of the insured. Normally, the trust is also beneficiary of the policy. Properly drawn, these irrevocable trusts provide several benefits.
ILIT Pros and Cons
An ILIT may still be a necessary estate planning vehicle for some. For the following ILIT top 10 list, there are 7 ILIT pros and 3 ILIT cons listed below.
First, the ILIT functions so that the death benefit will be excluded from the estate of the insured. In contrast, if the decedent owns the policy the death benefits will be in his/her estate for Federal estate tax purposes and potentially subject to a 40% tax rate if it exceeds the current 2018 exemption amount of $11.2 million.
Second, the trustee of the ILIT can pay the premiums on the policy through contributions made to the trust by the insured. The payments are sheltered from gift tax for up to $15,000/year per life insurance beneficiary through the use of a special provision called a Crummey power (called a Crummey clause or power, not because they are poorly drawn, but because of a famous Tax Court case involving a taxpayer named Crummey).
Third, the life insurance cash surrender value will normally be protected from the insured’s creditors. Otherwise, the cash surrender value may be exposed to creditors depending upon a variety of factors, including local state law provisions.
Fourth, the ILIT can provide that any amounts payable to beneficiaries be distributed at an appropriate age. Typically, a trustee will have the discretion to distribute funds for the health, education and welfare of the individual, but can withhold mandatory distributions until 25, 30, 35, or older, depending upon the wishes to the grantor of the trust. Absent the use of a trust, beneficiaries can generally access funds upon turning age 18, and few 18-year olds possess the judgment to handle getting a blank check at such a young age.
Fifth, the use of a life insurance trust can provide asset protection against creditors of the beneficiaries, and against the financial imprudence of the beneficiaries themselves. The trust can grant the trustee certain discretionary powers that allows the trustee to withhold gifts if the beneficiary does not meet specific requirements.
Sixth, an ILIT can provide professional funds management to otherwise financially inexperienced beneficiaries. The grantor of the trust can create specific objectives for the beneficiaries in the trust to get trust funds. For example, the grantor may state the beneficiary must read certain books, take certain financial education courses, etc.
Seventh, a irrevocable trust can provide for the surviving spouse while protecting the children’s inheritance in case of the surviving spouse’s remarriage. Otherwise, what may occur is the surviving spouse remarries, and the new spouse has previous children as well. The inheritance will now pass on to the new children in some cases, diluting your children’s gift.
First, one drawback of an ILIT is that you lose control. For the ILIT to be recognized, the grantor must give control over to the trustee of the trust. Otherwise, the ILIT will fail and the life insurance will be pulled into the estate, which could lead to potential estate taxes.
Second, another negative of a life insurance trust is it may no longer be necessary since the Federal estate tax exemption amount is so high. Previously when the exemption amount was $1,000,000 or less, it made sense to set up an ILIT. In 1999, the exemption amount was $650,000. You can see a full breakdown of the exemption history here.
Third, another potential negative of an irrevocable life insurance trust is the ILIT might not be legitimized. There is a three-year lookback rule that requires the life insurance to be in the trust for 3 years before the death of the insured. There are workarounds, such as setting up the ILIT in advance or adding an estate planning rider to the policy.
An experienced estate planning attorney can prepare an irrevocable life insurance trust to meet your specific needs and objectives. However, remember that DIY estate planning is seldom the best choice, as most trust forms rarely, if ever, meet the needs of the individual.
Eric S. Ratliff, JD, LLM
Ratliff Law Firm
740 Pollard Road
Kodak, TN 37764