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Understanding Life Insurance Trusts (ILITs)

  1. 1. What does a life insurance trust do?

An irrevocable life insurance trust gives you more control over your insurance policies and the money that is paid from them. It also lets you reduce or even eliminate estate taxes, so more of your estate can go to your loved ones.

  1. 2. What are estate taxes?

Estate taxes are different from, and in addition to, probate expenses and final income taxes which are due on the income you receive in the year you die. Federal estate taxes are expensive (historically 45-55%) and they must be paid in cash, usually within nine months after you die. Because few estates have the cash, it has often been necessary to liquidate assets to pay these taxes. But if you plan ahead, estate taxes can be reduced or even eliminated.

  1. 3. Who has to pay estate taxes?

Your estate will have to pay federal estate taxes if its net value when you die is more than the exempt amount set by Congress at that time.  The federal exemption is $5 million (adjusted for inflation in 2012) and the tax rate is 35%. Some states have their own death or inheritance tax, so your estate could be exempt from federal tax and still have to pay state tax.

The Irrevocable Life Insurance Trust (or “ILIT” as it is frequently called) has proven to be a highly effective method of avoiding estate taxes.  The tax on your estate is due nine months after the date of death. Those with large estates often do not have sufficient cash or other assets which could be easily converted to cash within the nine month time frame. The need to pay estate taxes has caused many a farm, family business, or major real estate holding to be sold at discounted prices to pay the estate tax.

Life insurance may provide the money needed to pay the estate tax, and by having the policy purchased and held in an ILIT, the proceeds may be used to provide the needed liquidity for your estate and yet not be subject to estate tax on your death.

Married couples may wish to consider using a “second-to-die” policy which pays the death benefit only after both spouses are deceased. That is usually the exact time that the proceeds are needed to pay the estate taxes. Because no death benefit is paid on the first death, the premium is much lower than purchasing a policy which insures just one life.

  1. 4. What makes up my net estate?

To determine your current net estate, add your assets then subtract your debts. Insurance policies in which you have any “incidents of ownership” are included in your taxable estate. This includes policies you can borrow against, assign or cancel, or for which you can revoke an assignment, or can name or change the beneficiary. You can see how life insurance can increase the size of your estate and the amount of estate taxes that must be paid.

  1. 5. How does an insurance trust reduce estate taxes?

The insurance trust owns your insurance policies for you. Since you don’t personally own the insurance or have any incidents of ownership, it will not be included in your estate — so your estate taxes are reduced. (There is a three-year rule for existing policies, but if the ILIT purchases the policy the three-year rule is eliminated).  If you die within three years of the date of the transfer of an existing life insurance policy, it will be considered invalid by the IRS and the insurance will be included in your taxable estate. There may also be a gift tax.

  1. 1. If the trust buys the insurance, it will not be included in your estate. So the proceeds, which are not subject to probate or income taxes, will also be free from estate taxes.
  2. 2. Insurance proceeds are available right after you die. So your assets will not have to be liquidated to pay estate taxes.
  3. 3. Life insurance can be an inexpensive way to pay estate taxes and other expenses. So you can leave more to your loved ones.
  4. 4. How does an irrevocable insurance trust work?

An insurance trust has three components. The grantor is the person creating the trust — that’s you. The trustee you select manages the trust. And the trust beneficiaries you name will receive the trust assets after you die.

The trustee purchases an insurance policy, with you as the insured, and the trust as owner. When the insurance benefit is paid after your death, the trustee will collect the funds, make them available to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits), and then distribute them to your beneficiaries as you have instructed in your Last Will and Testament or Revocable Trust

  1. 7. Can I be my own trustee?

Not if you want the tax advantages we’ve explained. Some people name their spouse and/or adult children as trustee(s).

  1. 8. Why not just name someone else as owner of my insurance policy?

If someone else, like your spouse or adult child, owns a policy on your life and dies first, the cash/termination value will be in his/her taxable estate. That doesn’t help much.

But, more importantly, if someone else owns the policy, you lose control. This person could change the beneficiary, take the cash value, or even cancel the policy, leaving you with no insurance. You may trust this person now, but you could have problems later on. The policy could even be garnished to help satisfy the other person’s creditors. An insurance trust is safer; it lets you reduce estate taxes and keep control.

  1. 9. How does an insurance trust give me control?

With an insurance trust, your trust owns the policy. The trustee you select must follow the instructions you put in your trust. And with your insurance trust as beneficiary of the policies, you will even have more control over the proceeds.

  1. 10. Are there other benefits to naming the trust as beneficiary of an insurance policy?

Yes. If you name an individual as beneficiary of a policy and that person is incapacitated when you die, the court will probably take control of the money. Most insurance companies will not knowingly pay to an incompetent person, and will usually insist on court supervision. But if your trust is beneficiary of the policy, the trustee can use the proceeds to provide for your loved one without court interference.

  1. 11. Who can be beneficiaries of the trust?

You can name any person or organization you wish. Most people name their spouse, children and/or grandchildren.

  1. 12. Where does the trustee get the money to purchase a new insurance policy?

From you, but in a special way. If you transfer money directly to the trustee, there could be a gift tax. But you can make annual tax-free gifts of up to $14,000 ($28,000 if your spouse joins you) to each beneficiary of your trust. (Amounts may increase periodically for inflation.) If you give more than this, the excess is applied to your federal gift/estate tax exemption.

Instead of making a gift directly to a beneficiary, you give it to the trustee for the benefit of each beneficiary. The trustee notifies each beneficiary that a gift has been received on his/her behalf (Crummey Notice) and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds — by paying the premium on the insurance policy. Each beneficiary must understand the consequences of taking the gift now; for example, it may reduce the trustee’s ability to pay premiums.

  1. 13. Can I make any changes to the trust?

An insurance trust is irrevocable, which generally means you cannot make changes to it. However, under the Uniform Trust Code (UTC) you may be able to make some changes. Still, you should read the trust document carefully before you sign it.

  1. 14. When should I set up an insurance trust?

You can set up one at any time, but because the trust is irrevocable many people wait until they are in their 50s or 60s. By then, family relationships have usually settled. Just don’t wait too long; you could become uninsurable. And remember, if you transfer existing policies to the trust, you must live three years after the transfer for it to be valid.

  1. 15. Should I seek professional assistance?

Yes. If you think an irrevocable insurance trust would be of value to you and your family, talk with an insurance professional, estate planning attorney, or CPA who has experience with these trusts.

  1. 16. Benefits of a Life Insurance Trust

  • –  Provides immediate cash to pay estate taxes and other expenses after death.
  • –  Reduces estate taxes by removing insurance from your estate.
  • –  Inexpensive way to pay estate taxes.
  • –  Proceeds avoid probate and are free from income and estate taxes.
  • –  Gives you maximum control over insurance policy and how proceeds are used.
  • –  Can provide income to spouse without insurance proceeds being included in spouse’s estate.
  • –  Prevents court from controlling insurance proceeds if beneficiary is incapacitated.

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