Irrevocable life insurance trusts (ILIT) are special trusts that can serve both the beneficiary and the owner of a life insurance policy. It can help you with both estate planning and financial planning.
An ILIT can help protect your assets, such as large life insurance death benefits. That way, they will not have estate taxes owed on them. Understanding ILITs starts with understanding estate taxes.
About Estate Taxes
In the U.S., you can transfer both your assets and your property to one or more beneficiaries after you have died. Even though you have this right, both the state and federal governments can also tax that property and assets’ value to get their share.
Estate taxes are ones that are collected against your property’s fair market value when it is transferred. That means that even if you don’t have to pay the tax when you are alive, your estate still may have to do so.
If your estate will need to pay estate taxes once you pass, then the amount that the beneficiaries get might not be as large. Many times, people don’t want to pay more taxes than necessary, even once they have died. So, if your property might be subject to these taxes, you need to do a bit of estate planning.
Estate Tax Exemptions and Marital Exclusions
If you want to control who gets custody of your children, where your wealth goes, and other important decisions for after you pass, then you need to make an estate plan and a will.
However, families that have a certain net worth are usually the ones who can plan for estate taxes. This is because of the current exclusions and estate tax limits that are in place.
First, you have the marital exclusion. This says that for citizens of the United States, surviving spouses can get an unlimited deduction.
This means that there will not be estate taxes due on assets or property, such as those from life insurance policies, when they are being given to a spouse that has survived.
Plus, there are no limits on the property that you can transfer to a spouse both after and during your life. Because of this exclusion, you do not have to worry about estate taxes until the surviving spouse is the one to die.
Even once the surviving spouse dies, most people do not have to worry about estate taxes for a transferred property. This is because of the federal exemption to estate taxes. This is the value of your property in United States dollars that you can transfer to your beneficiaries before having to worry about the estate tax.
In other words, this is the amount that you can give to others after your death that will not be subject to estate taxes. This amount has risen over the past several years. For example, in 2018, the exemption was $5.6 million, but in 2020, it rose to $11.58 million for individuals.
But if your gross estate value and joint net worth might be higher than that amount, then you might want to start thinking about strategies to reduce your estate taxes. That might include having an irrevocable life insurance trust.
Of course, states have individual laws, so even if you don’t face federal estate taxes, you may still have to pay taxes on the estate to the state. It is a good idea to check the laws in your state when you are considering whether to get an ILIT.
For instance, if your state had an estate tax on anything worth $1 million or more, you might reach that threshold sooner than you thought. If your home was worth $400,000 and you had a $600,000 life insurance policy, your estate might owe a large tax bill once you passed away.
What an ILIT Is
This type of trust is a kind of tool used for estate planning. It allows you to potentially exclude proceeds from life insurance policies from estate taxation. This is because the tool acts as both the beneficiary and the owner of a life insurance policy.
If the owner of a big life insurance policy dies and the estate value is bigger than the federal estate tax exemption, the benefit from that policy might have large estate taxes owed on it.
However, if the ILIT is the beneficiary and the owner, it can shield the benefit from the estate tax. Think of it as a kind of go-between between the beneficiaries and the death benefit.
For the proceeds to benefit the intended people, such as the children of the deceased person, there are beneficiaries for the ILIT. The trustee will invest the proceeds and then administer them.
The benefit from this policy is designed to help the beneficiaries of large estates pay their estate taxes without needing to dip into the estate’s value. That might or might not be liquid.
Having an ILIT can be very helpful when it comes to transferring large proceeds from life insurance so that you don’t have to pay estate taxes on them. It can help provide cash to pay any estate taxes on the rest of the assets. However, there are still a couple of things to keep in mind about ILITs.
Considerations with ILITs
If you have an ILIT, then it is irrevocable. What this means is that once you have it in place, you cannot amend or reverse it. This is one of the main drawbacks when it comes to establishing this type of trust.
Your circumstances and your life can change quite a bit. But because it is irrevocable, this is also the defining feature that can exclude the proceeds of life insurance policies from your estate taxes.
Because the trust owns the policies and they can’t be revoked, the insured people can’t be deemed as having ownership incidents. That determines whether an asset might be subject to estate taxes.
You will also want to think about the costs and complexities of establishing this trust. Plus, think about how maintaining it will be. However, if your estate is big enough that it will be subject to estate taxes, then you might want to think about having an irrevocable life insurance trust.
Will You Benefit from Having an ILIT?
The purpose of having an ILIT is to reduce your estate taxes, so think about whether your estate will have federal or state estate taxes once you and your spouse die. The estate taxes do have frequent changes to them, and your net worth might change a bit over time.
This means that if you do not choose to get an ILIT right now, you may need to reconsider your decision over time. That is where having a financial planner or estate planning lawyer can be helpful for you.
If the beneficiaries on your plan are adults that have poor spending habits, then it can be a good idea to create an ILIT. The same is true if you have minors or even adults that have patterns of substance abuse or alcohol. Have the trust as a beneficiary to help protect these people.
The trust can help reduce any potentially irresponsible behavior. Appointing a trustee allows you to have someone supervise your trust, so they can distribute your assets according to your wishes. The trust document will lay this out for you.
Another reason might want to consider getting an irrevocable life insurance trust is that it can offer a bit of protection of the assets for your beneficiaries. That way, if they have future litigations, the assets will still be protected.
This is because the beneficiaries do not own the ILIT. That makes it a bit harder for the courts to link the beneficiary and the assets together. This makes it harder for creditors to get to them.
Setting Up Your ILIT
If you have decided that getting an ILIT is the best strategy to try to reduce your estate taxes, you will need to have an attorney help you set it up. You should choose a lawyer whose specialty is estate planning. To draft up the document to get the plan going, you should make a few important decisions, such as:
- Who will your trustee be?
- Will you buy a whole new insurance policy for the trust, or will you transfer a policy you already have?
- Who will benefit from the life insurance proceeds?
Once you make decisions about this type of trust, you can’t change them. Remember that with a revocable living trust, you can change the decisions. But if the living trust is irrevocable, you don’t have that much flexibility.
However, if you live for three years or longer after transferring life insurance policies to your ILIT, your proceeds can go outside of your estate. And if the trust itself purchases policies, then there is no minimum longevity. Doing this can save you from a potentially large estate tax bill and help your beneficiaries get more money.