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ILIT – Life Insurance Trust [In-Depth Comprehensive Guide]

irrevocable life insurance trust

The Ultimate Financial Flexibility and Control

Using Insurance Trusts or “Grantor Trusts”, to Reduce (or Eliminate) Asset Transfer Taxes and Decide What Happens with Your Savings, Property, and/or Business – Now and In the Future

While you may have spent a great deal of your life thinking about offense (by saving, investing, and trying to build up your net worth), it is equally important to think about defense (by implementing measures to protect what you have built and saved). A key part of your defensive strategy is to decide what will happen to your assets once you (and your spouse, if applicable) are no longer here.

Defense is important because without a plan in place, everything that you have worked for could be significantly reduced by unnecessary taxes, court probate costs and complications, rogue creditors, and other types of “predators”.   Without defense, your hard earned assets may be doled out according to state law…and the recipient(s) of your property and other assets may not necessarily be who you intended them to go to.

However, by using the right planning strategies, you can mitigate all of the above, including reducing or eliminating taxes on asset transfers, in turn.  Defensive planning can, and generally does result in much more being left and key instructions for those you love and care about.

One powerful defensive strategy that is often utilized way is using properly structured life insurance trust or a grantor trust designed to hold life insurance for future generations.

Why Trusts Can Be Ideal Protectors of Assets

As discussed above, building wealth is just one component of a complete financial plan. For all of the reasons mentioned, protecting what you have built up by implementing a defensive strategy is also a crucial piece of the puzzle. One way to do this is through a properly drafted grantor trust that is designed to hold life insurance, often referred to as an irrevocable life insurance trust.

There are several ways that irrevocable trusts can provide asset protection, along with more control over what happens to your assets, both now and in the future. Just some of the reasons why trusts can be ideal protectors of assets are because they allow you to:

  • Place conditions on when and how your assets get distributed after you pass away
  • Reduce – or possibly even eliminate – estate and/or gift taxes
  • Distribute assets to your loved ones efficiently – and without the cost, time, and publicity that is associated with the probate process

How Trusts Work

As a bit of background, in general a trust is a type of legal device that is oftentimes used for managing assets and/or property. Through a trust, one individual – the grantor – transfers the legal title to another (the trustee), who will then manage it in a specified manner for the benefit of a third party, or a beneficiary.

what is a family trustThere are different types of trusts that may be used. For instance, a “living” trust is set up – and takes effect – during the grantor’s lifetime, whereas a “testamentary” trust is created by one’s “will” and does not actually go into effect until you pass away.

Revocable versus Irrevocable Trusts

In addition to living trusts and testamentary trusts, a living trust can also be broken down further as either revocable or irrevocable.

With a revocable trust, you are allowed to retain full control of all of the assets that you place into the trust. In addition, you have the freedom to change or “revoke” the terms and conditions of the trust at any time.

Therefore, if you have second thoughts about any (or all) of the provisions in the trust, they may be modified. Likewise, if any major changes take place in your life – such as divorce – you have the freedom to make changes to a revocable trust as necessary, such as revising the beneficiary designation on various assets.

Revocable

Revocable trusts are a fairly common planning tool if one of your goals is to avoid probate. This is because the assets and property that are in a revocable trust will pass directly to the trust beneficiary (or beneficiaries) upon your (i.e., the grantor’s) passing.

Because you (the grantor) are still considered the owner of the property and/or assets that are in a revocable trust, though, they will still be included in the overall value of your estate for estate tax purposes at your death. This could add to the amount of any estate taxes that are due. In addition, the assets that are in a revocable trust may also be at risk if you are sued or you file for bankruptcy.

Irrevocable

Conversely, an irrevocable trust does not allow you to have full control of any of the assets that are inside of it. You are also not allowed to make changes to an irrevocable trust – at least not without the consent of the beneficiary(ies). In addition, an irrevocable trust may not be terminated by the settlor once it has been created.  The irrevocable life insurance trust falls into this category of trust type because it is irrevocable (vs. revocable) as we will discuss in more detail to follow.

The “tradeoff” for this inflexibility, though, is that the assets that are in an irrevocable trust are no longer considered to be owned by you. Therefore, at your passing, these assets will NOT be included in the value of your estate, nor will they be subject to estate taxes. This is one of the MAIN REASONS why irrevocable trusts are used in estate planning strategies.

Holding assets in an irrevocable trust can also be beneficial during your (the grantor’s) lifetime. This is because when assets are placed into the trust and they are removed from your estate, they are not able to be obtained by creditors.

Revocable versus Irrevocable Trusts

Revocable Trust Irrevocable Trust
Flexibility Terms may be changed during your lifetime The terms are locked in at the time the trust is created
Control You retain total control over your assets that are in the trust You do not have control of the assets once they are in the trust
Estate Tax Heirs could still be subject to estate taxes No tax is levied on the assets inside of the trust
Protection from Creditors Not protected from creditors or lawsuits Offers protection from lawsuits and creditors

 

Using Life Insurance Trusts for Added Flexibility and Control

While many people do not like to think about life insurance because it brings to mind their mortality, the truth is that this financial vehicle is extremely flexible, and benefits can be attained both after the insured dies, as well as during his or her lifetime. This is particularly the case when it is used in conjunction with a trust.

ILIT

With all of the above aspects of trust planning in mind, one of the most commonly used estate planning strategies, involving irrevocable grantor trusts, is the ILIT, or irrevocable life insurance trust.

An irrevocable life insurance trust, or ILIT, involves a trust created by a grantor with the intent for a life insurance policy to be owned by the trust – as versus by an individual – for the purpose of keeping the death benefit proceeds out of a person’s individual estate, thereby reducing the amount of taxable assets in the estate, and in turn, reducing the amount of estate tax that may be due and payable by the estate following the estate owner’s death.

Although the premium for the life insurance policy (or policies) inside of an ILIT can be paid in a number of ways, one strategy involves using an individual’s annual gift tax exclusion ($16,000 in 2022), which not only funds the insurance coverage, but also removes funds from the donor’s taxable estate.

Business Succession Planning with Life Insurance Trusts

If you own a business, it may be possible to use a life insurance trust to provide the means to transfer it to one or more loved ones, while at the same time keeping it protected from large tax liabilities. An ILIT can be particularly beneficial if the value of the company has grown since you put your initial business succession planning into place.

family business succession planningOne way this works is that the “gap” between what the company is worth when you planned your estate and what it is valued at when you pass away could be managed – along with various other liquidity issues – by setting up an irrevocable life insurance trust.

If the trust is properly structured, the benefits that are paid out from the life insurance policy will not have to pass through probate. Therefore, these funds will be immediately accessible to the beneficiary(ies) so that cash is available for estate taxes and other needs.

Such other needs may also be utilizing funds to acquire a business from other heirs or from the estate itself.  This is important because liquidity is often needed to keep a business in tact during transition, especially given the fact that estate taxes are due within 9 months of the owner’s date of death.

Likewise, the assets that were used to fund the irrevocable trust can also bypass probate and the trust will be able to avoid taxes – as well as claims that are made by creditors – at the time of death.

Should You Consider a Life Insurance Trust?

When making this decision, it is important to consider all factors impacting the estate.  There are many reasons to consider using a life insurance trust in your overall estate planning.

However, because everyone’s needs and goals can differ, this may not necessarily be the right strategy for all individuals or families. Given the right circumstances, though, an ILIT could be extremely beneficial for accomplishing the following objectives:

  • Minimizing estate taxes and facilitating wealth transfers
  • Avoiding gift taxation
  • Providing liquidity for your survivors
  • Protecting government benefits
  • Protecting assets from creditors
  • Making distributions from the trust
  • Creating a legacy far into the future

For instance, the primary reason that many people use irrevocable life insurance trusts is to remove the death benefit of a policy from the total gross estate value of the grantor, in turn, reducing the asset “base” from which to calculate estate taxes.

If any estate taxes are due from the estate, the proceeds of the life insurance policy may be used for paying some or all of these, or these funds could alternatively be used to reimburse your survivors for the estate taxes that are paid.

ILITs may also be used to help avoid gift taxation. One of the common methods for paying the life insurance premium for a policy that is held and owned by an irrevocable life insurance trust is to use the grantor’s annual gift tax exclusion to fund it every year.

In 2022, the annual gift tax exclusion is $16,000 per donor, per recipient. This means that you can gift up to $16,000 to as many individuals or entities that you want, free of federal gift taxes – and if you are married, you and your spouse together can gift up to $32,000 gift tax free.

Crummey Letters

It is important to note here that in order to avoid gift taxes, it is essential that the trustee use Crummey letters to notify the beneficiary(ies) of the trust regarding their right to withdraw a share of the contributions for a 30-day period of time.

Once the 30 days has elapsed, the trustee may then use the contribution(s) to pay the premium on the life insurance policy. A Crummey letter will quality the transfer for the annual gift tax exclusion by making the gift a present – rather than a future – interest, in turn, avoiding the need to file a gift tax return (in most cases).

Crummy Power

“Crummey power” is a strategy that allows an individual to receive a gift that is not eligible for a gift tax exclusion, and then change it into a gift that is eligible. In order for the Crummey power to work, though, it must be stipulated that the gift is in fact a part of the trust when it is drafted.

It may also be possible to give an individual more than $16,000 (in 2022) per year, and in doing so, apply the excess towards your lifetime estate tax exemption (which is $12.06 million in 2022).

Another key reason for the use of irrevocable life insurance trusts is to provide liquidity for the owner’s gross estate – as well as for the gross estate of other named individuals, such as a surviving spouse.

In this case, a surviving spouse may require funds for paying off debt and/or replacing lost income (such as that from Social Security, or a single life pension or annuity) so that he or she will not have to alter their lifestyle at an already difficult time in their life.

Charitable Trust

In other situations, an irrevocable life insurance trust could be created in order to offset assets that have been given to a charity. For instance, an individual may make a direct gift to a charitable organization, or a charitable remainder trust could be created.

Because the charitable entity – rather than the insured’s heirs – receives the assets at the time of the donor’s passing, the irrevocable life insurance trust could be set up to benefit the family members and as such, “replace” the value of the assets that went to the charity.

Special Needs Child

If you have a special needs child or other loved one(s), it is possible that he or she receives financial assistance through the government via programs like SSI (Supplemental Security Income) or Medicaid.

Unfortunately, if this individual receives a large (or even a moderate) sum of money – such as funds through an inheritance – it could render them ineligible to continue receiving these benefits.

But having the proceeds from a life insurance policy that is owned by an irrevocable life insurance trust (ILIT) could help to protect the benefits of a special needs trust beneficiary, provided that the trustee properly controls how the trust distributions are used so as not to interfere with the government income.

Oftentimes – especially when an estate goes through the probate process – an individual’s assets become public knowledge, and creditors may come forward to request money that is due to them. In some instances, financial predators might also try to stake a claim to the assets.

Creditor Protection

While all states can have differing rules and limits with regard to how much of a life insurance policy’s death benefit and cash value are protected from creditors, any amount of coverage that is above such limits – and that is held in an irrevocable life insurance trust – will typically be protected from the creditors of both the trust grantor and the beneficiary(ies).

An ILIT can also help to ensure that assets from the trust are not squandered by a “spend thrift” beneficiary and/or be available to an unintended recipient, such as a beneficiary’s ex-spouse. This is because the trustee of an irrevocable life insurance trust can be given discretionary powers for making distributions.

Control Payout

The trustee may also have control over when the proceeds of the life insurance policy in the ILIT are paid out – such as immediately or over a certain period of time. As the grantor of an irrevocable life insurance trust, you could even specify exactly when and how the trust’s beneficiary(ies) receive their distribution(s).

Many people who wish to leave a legacy also make use of irrevocable life insurance trusts. Because the life insurance policy’s death benefit proceeds are not included in the trust grantor’s estate, it is possible that multiple generations of a family – such as children, grandchildren, great-grandchildren, and so on – could benefit from the trust’s assets.

With that in mind, and given all of the benefits that an ILIT can provide, are you a good candidate for an irrevocable life insurance trust?

The answer is… maybe.

All situations are different. However, an ILIT could be a viable solution for you if you:

  • May have an estate tax issue upon your (or your spouse’s) passing
  • Want to ensure that a special needs loved one will be taken care of financially (and continue to receive their government benefits) – even when you are no longer here
  • Would like to leave a legacy for future generations
  • Want to have more control over which of your assets go where – and when those assets are distributed
  • Are aiming to reduce (or eliminate) taxation so that the people and/or entities that you care about are able to receive more in terms of net proceeds

Comparing Policies from Mutual versus Stock Life Insurance Companies

If it appears that a life insurance trust will be beneficial for you, based on your goals and needs, an important step in the process is choosing the actual life insurance policy that will be placed in the trust.

In some cases, an already-existing life insurance policy may be transferred to the ILIT trust, while in other instances, a new policy is purchased. Where that policy is purchased from can make a difference, though.

There are two major types of insurance companies in the industry today. These include stock insurers and mutual insurers. Stock insurance companies are owned by their shareholders, and as such, they typically have a goal of making a profit for their investors. With stock insurance carriers, the policy holders have little or no say in how the business is run. Nor do they receive a share of the company’s profits.

A mutual insurance company, however, is owned by – and for the benefit of – its policy holders. The policy holders of a mutual insurance carrier have the right to vote on its board of directors. In addition, these companies are managed, and the assets – such as surplus, insurance reserves, and contingency funds – are held for the benefit and protection of the policy holders, as well as for their beneficiaries.

Dividends

whole life insurance dividendsPlus, although it is not guaranteed, operating income is oftentimes paid out to the policy holders of mutual insurance companies in the form of life insurance dividends.

These participating policy owner dividends may be taken by the policy holder in the form of cash, or alternatively, added to the cash value of the policy, or even used to purchase additional life insurance coverage. Some mutual insurance companies have paid out dividends consistently every year – without interruption – for more than a century.

Are Your Assets – and Your Loved Ones – Properly Protected Now and in the Future?

If the assets that you have built up over your lifetime may be at risk of taxation upon transfer and/or they may be held up in probate or reduced by the claims of creditors, a life insurance trust could help you to prevent this from happening.

Even with the many benefits that life insurance trusts can offer, though, there is no such thing as a one-size-fits-all solution – and not setting up the plan properly could end up doing more harm than good for you and those that you love and care about.

That’s why is it recommended that you first discuss your objectives with a specialist in this area.

So, if you would like additional information, or if you would prefer to schedule an initial consultation, please give us a call today.

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