Life insurance can be a key financial asset for families, so much so that policies are often placed in a specialized type of trust called an irrevocable life insurance trust (ILIT).
Used properly, an ILIT can help you reduce estate tax liability, protect your heirs from creditors and ensure privacy. Before setting up this type of trust, it’s important to understand potential drawbacks, which include inflexibility and unintended tax consequences. Here’s what you should know.
How an ILIT Is Structured
ILITs are set up during the lifetime of an individual whose life is covered, either by a term or permanent life insurance policy. The policy is placed within the trust, which then owns and controls it. Another option is to fund the ILIT with cash or other assets, and then the trustee of the ILIT purchases the policy. There are specific tax rules to be aware of depending on which route is taken. The ILIT, through its trustee, also manages and distributes funds to beneficiaries—typically family and loved ones—upon the death of the insured person and after the life insurance proceeds are collected.
Benefits of an ILIT
1. Reducing Estate Taxes: One of the principal reasons families use ILITs is to minimize estate taxes. Life insurance proceeds, known as the death benefit, are included in the owner’s gross estate—the total dollar value of their assets at the time of death. The benefit, depending on its size, can push the estate above or even well beyond state and federal estate-tax thresholds. Thirteen states levy estate taxes,1 starting as low as $1 million.2 A federal estate tax as high as 40% currently kicks in on individual estates over $12.06 million.3 If your life insurance policy is owned by an ILIT, however, the proceeds are not considered part of your and your spouse’s estate—and thus are sheltered from estate taxation.
2. Liquidity for Estate Taxes: Another benefit of an ILIT is that the death benefit can be used to pay estate taxes if the person’s estate does not have the liquidity to pay them. This is typically seen where a large business or farm is the main asset of an estate (which the family does not want to sell to pay estate taxes). It is important to note here that the ILIT will loan the money to the estate to pay the estate taxes in exchange for some type of note or even an exchange of assets with the estate.
3. Privacy: Upon your death, information about your estate may become available to the public, including friends and family members. Depending on how the assets are distributed, resentments and conflicts could arise among family members and others. Since assets within ILITs are no longer considered your property, they are not subject to the probate process and the details including payouts to beneficiaries and remain private.
4. Creditor Protection: If you leave debts behind, creditors can seek payment from your estate, and if your death benefit is part of your estate, it could be fair game. Creditors cannot claim part of your life insurance proceeds in an ILIT, however. This ensures that the entire death benefit will go to the trust’s designated beneficiaries.
Role of ILIT Trustees
As is true with other kinds of irrevocable trusts, ILIT trustees can be granted discretion to make distributions based on the needs and financial maturity of the beneficiaries. For example, they can pay insurance proceeds immediately to one beneficiary, while parceling out proceeds more carefully for heirs who are minors or who might be prone to reckless spending. In all cases, the Trust is the owner and beneficiary of the policy which is a critical part of keeping the policy out of one’s estate.
Disadvantages of ILITs
A Grantor who transfers an insurance policy to an ILIT permanently relinquishes control of the policy so no changes can be made (other than by the ILIT Trustee). The grantor cannot serve as trustee, while a third party, typically a bank executive or trusted family member, is normally chosen to serve.
While using an ILIT to transfer wealth to heirs may shield you from estate taxes, the other benefit is that the receipt of the policy proceeds by the ILIT is income-tax-free. Only when assets start earning income within the ILIT, and distributions are made to beneficiaries, will reportable income be passed out to the beneficiaries. In addition, under a rule meant to prevent so-called deathbed transfers, you must transfer your life insurance policy to your ILIT at least three years prior to your death (assuming you wish to fund an ILIT with an existing policy). If you fail to do so, the IRS will not honor the arrangement. The rule doesn’t apply if the policy is purchased by the trust after its creation.
Consult With Your Wealth Team
If your life insurance policy is likely to push your taxable estate into federal and/or estate-tax territory, an ILIT can serve as a powerful estate planning tool. But as with so many financial decisions, there are trade-offs. Your wealth team, including an estate planning attorney, can help you understand whether an ILIT makes sense for you and how it might fit into your overall wealth plan.
Sources:
1“17 States With Estate or Inheritance Taxes”
2“Does Your State Have an Estate or Inheritance Tax?”
3“Estate Tax”
Investment advisory services provided through Mariner Platform Solutions, LLC dba AdvicePeriod (“AdvicePeriod”). AdvicePeriod is an investment adviser registered with the SEC, headquartered in Overland Park, Kansas. Registration of an investment advisor does not imply a certain level of skill or training. AdvicePeriod is in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which AdvicePeriod transacts business and maintains clients. AdvicePeriod is either notice filed or qualifies for an exemption or exclusion from notice filing requirements in those states. Any subsequent, direct communication by AdvicePeriod with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about AdvicePeriod, including fees and services, please contact AdvicePeriod or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you invest or send money.
This is provided for informational and educational purposes only and does not consider any individual personal, financial, legal, or tax considerations. As such, the information contained herein is not intended to be personal legal, investment, tax advice, or recommendation. The information contained herein has been obtained from sources believed to be reliable, but we do not warrant the accuracy of the information. The use of trusts involves complex tax rules and regulations please consider the counsel of an experienced estate conservation professional before implementing a trust strategy.
April 2024 Market Commentary