Wednesday, June 15, 2022

What Is Irrevocable Life Insurance

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The Current Estate Tax Laws Are Set To Revert

How does an Irrevocable Life Insurance Trust work?

The new federal estate tax exemptions are temporary. Unless the laws are changed, these higher limits will sunset and revert back to prior limits beginning in 2026. Individuals with rapidly appreciating property or a growing business may want to consider âtaking advantage of these higher limits by creating a new trust or adding to an existing one before the limits are halved,â Elbert suggests.

What Are The Tax Considerations Of An Irrevocable Life Insurance Trust

Irrevocable trusts have a separate tax identification number and a very aggressive income tax schedule. However, the cash value accumulating in a life insurance policy is free from taxation as is the death benefit. So there are no tax issues with having a policy owned in an irrevocable life insurance trust.

If properly designed, an ILIT can allow the trustee access to the accumulated cash value, by taking loans and/or distributions on a cost basis, even while the insured is alive. However, once a death benefit has been paid, if the proceeds remain in the trust, any investment income earned and not distributed to the beneficiaries could be taxed.

Irrevocable Life Insurance Trusts are a powerful tool that should be considered in many wealth management plans to help ensure that your policy is used in the best possible way to benefit your family. We can help you properly structure your life insurance trust.

Individuals Who Want To Equalize Inheritances

If you have multiple beneficiaries but only have a unique asset that can’t be evenly distributed like a family farm or business, then the ILIT can help equalize the inheritance. ILITs create a pool of different assets that can be distributed based on equal value. So one child can receive the family business and the other child can receive the proceeds from the ILIT to make the inheritance equal.

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Protecting Assets From Creditors

If you think youre liable for certain legal proceedings, an irrevocable trust can protect you and your family from them.

Having a high-liability business that can face claims regardless of you living or dying can add stress to your family. With an irrevocable trust, your assets are protected from creditors.

Understanding Life Insurance Trusts

What is an Irrevocable Life Insurance Trust?

Irrevocable life insurance trusts are estate planning tools that are often used to allow for further flexibility to transfer wealth from a parent to their dependents. Furthermore, they can provide more control over your life insurance policy and how the money is paid from it once you pass away.

An insurance trust has three components you must be aware of:

  • Grantor: The person who is creating the trust
  • Trustee: The person who is managing the trust for you
  • Trust beneficiaries: Named individuals who will receive the assets in the trust after you die

For example, you could purchase a life insurance policy for yourself, making you the insured. You can then take this policy and transfer it into an irrevocable life insurance trust in which you would be the grantor and you could name your dependents as trustees.

If the grantor were to pass away, the life insurance death benefit is paid out into the trust, at which point the trustee would collect the funds and use them however the grantor requested. Usually, the grantor would set up the trust so that they can provide detailed instructions on how the funds would be used. One such way would be for the grantor to name their children as the trust beneficiaries, but there are many ways that these financial vessels can be utilized.

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Irrevocable Life Insurance Trust

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Since estate taxes are imposed upon all the assets in the estate, many people prefer to pay the taxes by rearranging some of these assets instead of relying on their current income.

One method of achieving this goal is the irrevocable life insurance trust . To prevent inclusion in the estate, an irrevocable trust cannot be revoked or amended by the grantor.

  • Funded irrevocable insurance trusts: This trust has income-producing assets transferred into it, which will pay the premiums on the insurance policy from the income earned. Irrevocable life insurance trusts are typically not funded with a single, lump-sum payment because the gift taxes on the assets transferred are the same as the federal estate taxes on assets remaining in the estate. Also, if the trust is a “grantor trust”for income tax purposes, the income earned on the assets would still be included on the income tax return of the insured grantor. See IRC Sec. 677.
  • Unfunded irrevocable insurance trusts: Although this trust is not totally unfunded, it usually just owns an insurance policy and the grantor makes annual gifts to the trust with which the trustee can pay the premiums.

Life Insurance & Your Estate

To understand ILITs, it is important to review exactly what life insurance is, and how life insurance is treated for estate tax purposes. At its core, life insurance is a tool for shifting the financial risk associated with the insureds death from the family and loved ones onto an insurance company. The mechanics of life insurance are straight forward: the policy owner pays a certain amount to the insurance company called a premium. The premium is often paid monthly, but it can be paid quarterly, annually, or even as a lump sum. In exchange, the insurance company promises to pay a sum to a beneficiary of your choice upon the death of the insured person. While in most cases the insured life and the policy owner are the same person, this is not always the case.

Life insurance payouts received by beneficiaries are not taxed as income for the beneficiary. Rather, the policy is often taxed as part of the deceaseds estate as per I.R.C. § 2042, which states that life insurance is included in the deceaseds estate if the policy is paid to the probate estate, or if the deceased possessed an incident of ownership at death. What this means is that if the insured person was the policy owner, the life insurance payout is included in their taxable estate.

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May Continue To Allow Receipt Of Government Benefits

Having the proceeds from a life insurance policy owned by an irrevocable life insurance trust can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid. The Trustee can carefully control how distributions from the trust are used so as not to interfere with the beneficiarys eligibility to receive government benefits.

How Does An Irrevocable Life Insurance Trust Work

Irrevocable Life Insurance Trust ILIT

Three main parties are involved in an ILIT trust: the grantor, the trustee, and beneficiaries. The grantor is the individual who sets up and funds the trust with a life insurance policy. In some cases, they may choose to own a second to die life insurance policy instead. This policy ensures two lives instead of just one, such as for a married couple, and only pays out a benefit once both individuals have passed away.

Once the grantor transfers their life insurance policy into the trust, they are giving up control and can no longer make any changes. Here, the appointed trustee is responsible for managing the ILIT along with the assets owned by it. One of their main responsibilities is to ensure that premium payments are made to the policy through the trust account.

When the life insurance policy kicks in, the trustee must then make sure that benefits are properly distributed to the beneficiaries of the trust. These individuals are often direct family members of the grantor, such as children or grandchildren.

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Should Your Life Insurance Be In An Irrevocable Trust

LIRP Life insurance retirement plan and glasses.

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If you are contemplating purchasing a new life insurance policy, be sure to discuss the use of an irrevocable life insurance trust with your advisors before you purchase the policy. An ILIT is an irrevocable trust that you create to hold a life insurance policy on your life. It is typically used to benefit your spouse and your children by holding the policy proceeds in trust after your death.

The main reason people create an ILIT is for estate tax savings. If you die owning the policy, the policy proceeds will be included in your estate and taxed for estate tax purposes. The current federal estate tax exemption is $11,700,000 . If your assets exceed that amount, your estate will be taxed on your death.

Keep in mind that the current $11,700,000 exemption amount is scheduled to drop to $5 million, adjusted for inflation, on December 31, 2025. It may drop sooner to an even lower amount now that the Democrats control the White House and Congress. Even if your estate is not federally taxable, your estate may be subject to state estate taxes. Massachusetts, for example, taxes estates in excess of $1 million. The use of an ILIT could allow your estate to save on state estate taxes resulting in more monies directed to your beneficiaries.

Here are three things you need to know about ILITs.

Funded Versus Unfunded Ilits

Do options exist for grantors who do not want to make annual premium payments to their ILITs? Yes, they can establish a funded ILIT. The majority of ILITs are unfunded. That is to say that the grantor will need to transfer funds to make premium payments at regular intervals. A funded ILIT differs from an unfunded ILIT in that the ILIT holds not only the insurance policy, but also an independent income producing asset. Whether this is stock, a royalty producing mineral right or some other asset is immaterial. What does matter is that the income from the independent investment is used to fund at least part of the insurance premiums.

Funded ILITs are uncommon because any income generated by the investment in the trust creates an immediate tax burden that must be paid by the grantor due to the IRSs application of IRC 677. For high net worth individuals and those with high W2 earnings, this may result in a significant tax burden. There are also substantial costs associated with conveying the income producing assets into the trust. Because these assets would typically be substantial, a grantor would either need to make many $14,000 transfers under their annual gift exclusion or would need to claim the transfer against their lifetime exemption. While funded ILITs are something to consider, they may not be right for you.

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Irrevocable Life Insurance Trusts What They Are And Why They Are Great

Lets start with a brief trust primer. Virtually all trusts can be identified as one of two types. A Revocable Trust, or an Irrevocable Trust. Each is exactly what it sounds like. A Revocable Trust may be revoked or terminated after its creation, generally by the person who created it. Conversely, an Irrevocable Trust may generally not be revoked after its creation.

What we will discuss is this article is a Life Insurance Trust what they are, their general purposes, benefits and their tax structure. Most commonly they are irrevocable and are referred to as an Irrevocable Life Insurance Trust or ILIT. However, there are instances where a revocable life insurance trust might be used. Well talk about why ILITs are generally irrevocable below.

While there are countless reasons or scenarios in which an ILIT might be beneficial, some of the most common reasons to create an ILIT as part of ones estate plan are as follows::

3) To provide replacement assets. Replacement assets can mean several things. It can mean the replacement of the income that would be lost by virtue of the death of the insured. It can also mean the replacement of assets that might be gifted to charity under a Will or during life. .

5) To accomplish estate tax savings. I dont generally like to use the term loophole when discussing tax law. But heres the thing: ILITs are one of the few remaining loopholes in estate tax planning.

Lets discuss how it works.

Some Trusts Are Irrevocable

7 Reasons for an Irrevocable Life Insurance Trust (ILIT)

However, when parents want to help make sure that no one is able to change the terms of the trust and how the money is distributed to their children, they often choose to put their policy in what is known as an irrevocable life insurance trust. The term irrevocable means that the terms of the trust are permanent and cannot be changed.

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Is Life Insurance Taxable In A Trust

When a named beneficiary receives life insurance proceeds, they typically dont pay income tax on it. However, the value of a life insurance policy’s death benefit can actually contribute to the value of the deceaseds estate, which may result in estate tax.

A strong estate plan starts with life insurance

When you die, the executor will determine the value of the assets in your estate. If your estate is valued over the exemption limit , then the federal estate tax will have to be paid on any amount over the threshold. When someone retains any “incidents of ownership” over their insurance policy, the dollar amount of the death benefit can actually add to the valuation of their estate.

Examples of ownership described by Section 2042 of IRS code include:

  • Holding the insurance policy

One way to avoid having your policy proceeds factor into your estate is by using a life insurance trust. Life insurance trusts can help you avoid incidents of ownership so the benefit is not considered part of the estate for estate tax purposes. That’s because the life insurance policy becomes trust property, and is no longer an asset owned by the policyholder.

What Is A Life Insurance Beneficiary

A life insurance beneficiary is a person or organization who will collect the money from your life insurance policy when you pass away. The money can be used for any purpose and it is usually tax-free. You can name any individual person as your beneficiary, and some people choose to name an organization, such as a church or non-profit, as their main beneficiary.

When you buy a life insurance policy, you also have the option to name two or more people as a beneficiary on your policy. This could be a spouse and a child, for example. You can also add a contingent beneficiary to your policy, who would receive your death benefit if the primary beneficiary were to pass away before they can claim the money.

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Provides Some Asset Protection

Each state has different rules and limits regarding how much cash value or death benefit is protected from . Any coverage above these limits held in an irrevocable life insurance trust is generally protected from the creditors of the grantor and/or beneficiary. The creditors may, however, attach any distributions made from the ILIT.

What Is The Crummey Letter Method

Irrevocable Life Insurance Trust – ILIT

When you fund your ILIT, you will do so by gifting a certain amount of cash to the trust each year to pay for the insurance premiums. Normally, such gifts would be subject to the gift tax. In order to avoid these gift taxes, your trustee can send out what is known as a Crummey Letter. This letter informs beneficiaries that they can ask for their share of the money put in for the premium payment within a certain amount of time. This letter must be sent to all beneficiaries each year letting them know they have immediate access to the money. This will avoid the premium payment being taxed as a gift up to the amount excluded by the federal government. At the time of this article, that is up to $15,000 per giftee.

Beneficiaries must be aware that they cannot actually take the money, otherwise there will not be sufficient funds to cover the premium and the policy will lapse. It is beneficial to let beneficiaries know this ahead of time, and be sure they are aware that the premium payment is minimal compared to what they will receive upon the policys payout.

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How Do You Get An Irrevocable Life Insurance Trust

To establish an ILIT, the grantor will first need to form the trust. The terms and conditions of the ILIT are set forth in a trust agreement which typically is prepared by an experienced tax or estate planning attorney. Once the trust is established, the grantor can either assign existing life insurance policies to the ILIT, or the ILIT can purchase the life insurance policies.

The trust will become the owner and the beneficiary of the life insurance policies. The grantor must also choose a trustee they can trust to carry out his wishes. The trustee will then need to make sure the insurance policy premiums are paid and the ILIT continues to follow all of the legal guidelines.

Creating an Irrevocable Life Insurance Trust can dramatically increase the liquidity of your estate, leverage the value of the annual $16,000 gift tax exclusion, and help ensure the proceeds of life insurance policies in an ILIT are not included in your estate. ILITs can provide an effective way for you to achieve multiple estate planning goals.

Introduction To Irrevocable Life Insurance Trusts

It is strange to admit, but life insurance is among the few investments we make primarily due to the fear we have of the unknown. How would our loved ones cope with our untimely demise? Could they return to work right away, pay for lifes expenses, and retire with dignity without us supporting them? Would the unexpected loss of income, grief, and lack of emotional stability cause them to live a life of poverty and missed opportunity? There is no way to know for certain how those closest to us would react to our passing, but life insurance can act as a cornerstone to an intelligently crafted estate plan. It may not be able to replace our physical presence, but it can replace lost income and ensure that those we love are empowered by our memory, rather than financially burdened by our passing.

Estate planning would be degrees of magnitude easier if the challenge of providing for our families after our passing was as simple as buying a well funded insurance plan and ensuring that our children and spouse were designated as beneficiaries. While that simple transaction may work well for adult children and spouses who are confident with financial management and their ability to make sound financial judgments in the most challenging of times, what is someone to do when they have a special needs adult child, a disabled spouse, a large estate, are facing liabilities at the time of your demise, or have complex final plans that require more than the stroke of a pen to see fulfilled?

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