The affluent have always had access to strategies designed to help them pass money to their heirs with minimal tax obligations. One of the most common estate tax planning strategies is an Irrevocable Life Insurance Trust (ILIT). An ILIT is easy to understand, relatively easy to implement, and in many situations, avoids the need to incorporate other wealth transfer or estate tax reduction techniques.
ILITs perform two basic functions. They can:
- provide liquidity to an estate to help pay estate taxes; and
- be used to replace wealth lost to taxes.
An ILIT also can be designed to provide assets for multiple beneficiaries with continuing professional management. But ILITs are not just a tool for the very wealthy; they also may prove effective for those of more modest means.
How an ILIT Works
The ILIT takes out a permanent life insurance policy on the life of the person who sets up the trust (the grantor), and the ILIT is the owner and beneficiary of that policy. Typically, the grantor pays the premiums on the life insurance through annual gifts – which have no gift tax consequences if they are $14,000 or less per beneficiary per year (as of 2015) and made, according to the trust document, under a “Crummey power” (described below).
At the grantor’s death, the life insurance company pays a death benefit that is income tax free to the beneficiary of the policy, which is the ILIT. The grantor’s heirs are named the beneficiaries of the ILIT, which is how the life insurance policy proceeds pass to them.
Since the grantor did not have rights of ownership, the life insurance proceeds generally are not included in his or her estate for estate tax purposes – so all of the death benefit passes to the heirs tax-free through the ILIT. Also, the trust can continue to hold money after the grantor’s death and manage it for the future benefit of heirs, using investment strategies that the grantor selected when the trust was created. An ILIT can be especially useful in providing for the future care of minor children and even unborn children when it utilizes professional management after the grantor’s death.
Trust Documents Must Be Customized
ILITs are not for everyone because they require the grantor to give up ownership and control of what may become a significant asset. Also, each ILIT document should be custom designed, because the grantor must give up control to a third-party trustee – either an experienced individual or a professional trust company. Specific instructions must be written in the document for the trustee to follow in such important matters as how life insurance proceeds will be managed after the grantor’s death and whether the trustee has any power of discretion.
For example, if the trust is designed to benefit four grandchildren, can the trustee pay out more money to those needing help with college expenses? Can the trustee make discretionary payments or arrangements to provide for a beneficiary with special needs, such as a learning-disabled child? The grantor can be specific in giving instructions during the trust design process, but may have limited flexibility once the trust has been created.
Complexities That Must Be Considered
If the grantor already owns a life insurance policy and gifts it to an ILIT, the policy must be held in the trust for at least three years if the death benefit is to escape inclusion in the grantor’s estate upon his or her death. If the ILIT is the original applicant and owner of the policy, the three-year rule does not apply. Also, if the ILIT purchases the life insurance policy from the grantor, the three year rule does not apply.
Yet another complex area involves the Crummey powers that should be written into the trust document, if the annual premiums are to avoid gift tax consequence. Using these powers, named after a landmark legal case, the life insurance premiums that the donor pays each year can qualify for the annual gift tax exclusion only if they are of a “present interest.” The Crummey court case held that premiums are of a present interest if beneficiaries have even a temporary right to withdraw them. In practice, beneficiaries who are granted Crummey powers rarely withdraw premiums, but they must be legally notified when contributions are made to the trust.
Important Things to Consider
If you are considering establishing an ILIT, you may want to seek the advice of:
- A Trusts & Estates attorney, who can help you: decide whether or not an ILIT is right for you; draft your ILIT document; identify a capable trustee; and implement the trust.
- A financial professional – such as a Chartered Life Underwriter (CLU), Chartered Financial Consultant (ChFC) or Certified Financial Planner (CFP) – who can review with you the various types of life insurance products that may be appropriate for funding your ILIT and help to coordinate the process.
Irrevocable Life Insurance Trusts are no longer for the very rich. Be sure to check with a trusts & estates attorney and your financial professional to see whether or not an ILIT would make sense in your personal situation. The benefits can be numerous, but they’re not for everyone.
Prepared by The Guardian Life Insurance Company of America. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.