An irrevocable life insurance trust or ILIT is a type of trust used in estate planning to reduce estate taxes in the U.S. In an irrevocable life insurance trust, the owner of a life insurance policy transfers the policy and/or money to pay life insurance premiums, to a trust for the benefit of his beneficiaries. The trust maintains ownership of the life insurance policy thereby keeping the policy proceeds out of the original policy ownerís estate for estate tax purposes. Because this type of trust is irrevocable, it typically cannot be changed or terminated by the person that makes the trust, referred to as the settlor or grantor.
In an irrevocable life insurance trust, actual ownership of the policy is transferred to the trust, rather than naming the trust as the beneficiary of the policy. If you set up an irrevocable life insurance trust as part of your estate plan, you will not have any right to the assets in the trust. For more on the implications of this, see irrevocable trusts.One reason for making a life insurance trust is to keep the proceeds of the policy out of the settlor's estate for estate tax purposes. Nevertheless, if the insured dies within three years of transferring the policy to the trust, the death benefit will be included in the gross estate of the insured. This is sometimes referred to as the three year rule. See 26 U.S. Code Section 2035 and other applicable portions of the I.R.C. Therefore, the settlor's estate will not benefit from a reduction in estate taxes if the settlor does not live long enough to comply with this requirement for ILIT's.Another complicated element of irrevocable life insurance trusts is the use of Crummey powers to lessen the impact of gift taxes. If you plan to use an ILIT as part of your
estate planning strategy, the trust form document may need to include a provision to allow transfers of funds to the trust to pay life insurance premiums that is drafted with gift tax issues in mind. The trustee of a life insurance trust must also be familiar with how to comply with these provisions. For information on Crummey powers, see Crummey Trust.
Making a Life Insurance Trust
The life insurance company that issues your policy or an insurance agent may tell you about the advantages of making a life insurance trust. However, you should not rely on an insurance company to prepare the paperwork to set up an ILIT on your behalf. This is a very complex type of estate planning trust that may cause all of the following types of taxes to be owed by you, your spouse, or your estate: income taxes, estate taxes, gift taxes, and generation skipping taxes. Before you commit to establishing this type of trust, ask a tax professional what types of federal and state tax returns you will be required to file and whether it will result in a change to the amount of tax you owe. Also, if you own existing life insurance policies and wish to use those policies to fund the trust rather than purchasing one or more new life insurance policies, it is important to discuss this with your trust lawyer.The ideal way to make an irrevocable life insurance trust is to retain an estate planning lawyer to review your overall estate plan and legacy planning goals. See finding an attorney. If an attorney determines an ILIT is the best type of trust to meet your needs, consult your CPA or tax professional to review your tax situation. Then, if you decide you want to proceed with making an ILIT, have your attorney prepare your trust documents and work with your life insurance provider to properly fund the trust. Because payment of ongoing life insurance premiums is an issue with this type of trust, an attorney can also advise on how to properly maintain or administer the trust without violating IRS regulations or other applicable laws. For more details, refer to our section on Trust Law.
Other Types of Estate Planning Trusts
If your primary purpose for making an estate planning trust is to control the timing and amount of distributions to your children or other beneficiaries, you may want to consider other types of trusts. For example, quiet trusts or silent trusts are sometimes used by individuals who want to delay the timing of when an heir or beneficiary will learn they may receive a substantial inheritance.Another type of trust that is often funded with life insurance is a funeral trust.
Advantages of Life Insurance Trusts
Some of the advantages of an irrevocable life insurance trust include:1. the policy proceeds are not included in probate, so creditors are prevented from making a claim against them;2. the policy proceeds are not included in the insuredís gross estate, thereby reducing estate taxes;3. the trust can be written in a manner that restricts the amount and manner of distribution of the trust funds to the beneficiaries; and
4. life insurance can be used to pay estate taxes of the insuredís estate or otherwise meet a
need for liquidity in the settlor's estate plan.An irrevocable life insurance trust can be funded with an existing life insurance policy or the grantor can put money or other assets in the trust to pay premiums on a policy to be purchased by the trust on the grantorís life. To establish an irrevocable life insurance trust, consult a lawyer who specializes in wills, trusts, and estates. You will also typically need to consult an accountant or tax advisor.
Disadvantages of Life Insurance Trusts
Some of the disadvantages of an irrevocable life insurance trust include:1. This is a complex tax planning method. Both the settlor or grantor and the trustee need to be extremely careful that all terms of the trust are followed. This trust is typically made for the purpose of achieving tax savings. However, unless there is strict compliance with the legal and regulatory requirements for this type of trust, the tax savings may not be achieved, despite the costs required to establish a life insurance trust.2. This type of trust is irrevocable. If you make an irrevocable life insurance trust, you cannot get back the money, property or other assets transferred to the trust if you change your mind.
3. Due to the complexities involved in drafting and maintaining this type of trust, as well as the requirement to manage the payment of life insurance premiums, there are substantial costs associated with this type of trust. Because federal and state tax laws and regulations change frequently, you will need to have your life insurance trust reviewed often. There are currently proposals to reform federal tax laws by changing or eliminating certain deductions and preventing some estate planning methods from being used to avoid estate, gift, and generation-skipping transfer taxes. Revising your life insurance trust due to changing tax laws will create additional expenses.
Key Points About Life Insurance Trusts
Whether you are an individual or couple planning to make a life insurance trust as part of your estate plan or a professional drafting a form for this type of trust, there are several key points to keep in mind, including the following:1. One of the primary goals of an irrevocable life insurance trust is to keep the insurance policy proceeds out of the gross estate of the settlor or the settlor's surviving spouse to minimize estate taxes. Therefore, the trust document must be drafted in a manner that complies with the applicable sections of the U.S. Internal Revenue Code, as well as other laws and regulations. Any applicable state taxes should also be taken into consideration when drafting the trust.2. Because of the three year rule applicable to this type of trust, the health and lifestyle of the settlor may be a consideration in whether a life insurance trust should be used to achieve the settlor's estate planning goals. Ask your estate planning attorney about any look back period that may apply.3. Although funds may need to be transferred to the life insurance trust to pay regular premiums, these funds may be subject to the gift tax. Consult the attorney that prepares your life insurance trust about the options available to address the issue of gift taxes and funding your life insurance trust. See
2020 Gifting Limits.4. An irrevocable life insurance trust must be drafted in a way that prevents the settlor or grantor from retaining any incidents of ownership. See 26 U.S. Code Section 2042 and other applicable provisions of the I.R.C. For example, the person that makes a life insurance trust generally cannot retain the power to make certain changes to the trust or to revoke or terminate the trust. If the trust is not properly drafted, it could result in the life insurance proceeds being included in the settlor's gross estate, thus generating a significant tax burden and defeating the purpose for making the trust. To comply with this requirement for ILIT's, the settlor may need to use a professional trustee. For tips on how to do this, see trust companies.5. To ensure the life insurance policy remains in effect, your estate plan should include other essential estate planning documents, such as a power of attorney for finances. If the health or mental capacity of the settlor declines, a durable power of attorney for finances will allow an agent to manage the settlor's financial affairs, which may include transferring funds to the trust to pay life insurance premiums. For information on making a financial power of attorney, see
Do You Need a Life Insurance Trust to Address Estate Tax Concerns?
Before going through the steps required to establish and fund an irrevocable life insurance trust, it is important to have a clear understanding about whether your estate is likely to be impacted by estate taxes. As a result of recent tax law changes, federal estate tax exemption amounts are substantial at this time, but are subject to change in the future. Currently, the lifetime federal estate tax exemption amount for 2020 is $11,580,000 per individual. If you are married, you should also determine whether your spouse's estate is likely to be impacted by estate taxes. For tips on whether your estate is likely to owe federal estate taxes, go to Estate Tax Info.Copyright 2020 Pennyborn.com. ALL RIGHTS RESERVED. Updated on December 5, 2019.
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