Nobody likes to talk about death.
Eventually, though, it’s one topic of conversation we all get to.
Life insurance is a sad but necessary part of that conversation. We take out policies that protect our families, our loved ones, by paying out in the event of our deaths.
Something not a lot of people know is that these policies can be taxed, after our deaths. This means the money you’ve set aside to benefit your family could take a large knock before they ever even see it.
Irrevocable life insurance trusts give us a way around this, though.
Today, we’ll be diving into the ins and outs of this kind of insurance protection, and what it has to offer you.
Join us, and make a change to your life insurance policy.
An irrevocable life insurance trust (or ILIT) is simpler than it sounds. The grantor sets up a trust and gives that trust an insurance policy to hold onto. They then relinquish ownership of that policy to a trustee, who makes decisions on their behalf.
This means that, once this entity is set up, the grantor gives up the right to make changes to the terms of this trust, and, as such, the insurance policy it owns. As the name implies, the trust is now irrevocable.
So, what does this change for the beneficiaries?
There are four main reasons people invest in ILITs as insurance policies:
- To keep up with the liquidity needs of their estates, after they die.
- To circumvent estate taxation, in the midst of their death proceedings. On a similar note, this also helps to protect their property from creditors.
- To cover the income needs of their named beneficiaries. This happens after their liquidity costs have been taken care of.
This kind of life insurance trust helps to make sure your life insurance is paid out to your beneficiaries, and not used to cover estate tax expenses.
It’s important to restate: once you’ve created an irrevocable life insurance trust, you can’t serve as a trustee on the policy. This is for two reasons:
- In order for a truly irrevocable life insurance trust, you can’t be involved in the decision-making associated with being a trustee.
- Incidents of ownership. The IRS considers any asset of your estate for taxation after your death. If you keep ownership of your ILIT, it becomes an asset. You could conceivably withdraw money from it, or change it in some way to benefit you, while you’re still alive.
Like we said: you’ll set it up and then step aside.
You Won't Have No Control At All
Now, don’t worry too much.
An irrevocable life insurance trust may need you to take a step back from the process after they’re set up. But that isn’t to say you don’t get any say in where your money is going.
Let’s start with the trustee (or trustees) in the policy.
Trusts aren’t anything new. The idea has been around for a long time. It’s a simple legal entity, set up to “hold” parts of your business or estate instead of you. And the captain of this metaphorical ship is your trustee.
And, good news: this can be anybody. Hand the reigns over to your brother, mother, best friend, or legal representative and have them handle changes on your behalf.
The same goes for the beneficiaries.
You may not be able to change who gets the proceeds of your life insurance policy after it’s set up. But, like any other insurance policy, you can set the parameters under which recipients are paid out after your death.
The basic conditions you set will have to be carried out.
And the potential benefits of a policy like this are gigantic.
IRIT Benefits You and Your Next of Plans
An ironclad irrevocable life insurance trust offers a host of advantages, especially in planning for your estate.
Protect What's Yours
The foremost reason for creating an ILIT is to exclude the life insurance funds from your taxable estate.
You might not think the value of your estate adds up to enough to pass the tax threshold, but depending on which state you live in, you might very well be wrong.
In a state where the exemption is lower than $1 million, the balance of a policy’s death benefits is often combined with the tax value of an estate.
With an irrevocable life insurance trust, you prevent the liquidation of your property after you die, to pay the taxes you owe.
You can transfer the ownership of your existing policy to it, as well. This means that, technically, there’s always time to take advantage of one of these trusts.
We say “technically” because there is the risk of creating this sort of trust too late. We’ll address this a little further in this article. For now, understand that you can either purchase the policy, via the trust or hand over ownership of an existing policy to a trust after it’s been formed.
Protect Your Beneficiaries
The way in which the irrevocable life insurance trust pays out is another of its biggest benefits.
When you die, the trust receives the full payout of your death benefits and holds them for payout to your beneficiaries.
Because these proceeds are held by the trust, payouts are made in increments rather than any single lump sum. This means the money your beneficiaries receive can’t be taxed as part of their estates.
Safeguard Against Gift Tax Losses
You can use it to skirt the consequences of gift taxes while paying your premiums. It also offers the handy benefit of giving your beneficiaries legal access to funds. These are transferred annually to the trust and are for premium payments, but they are available.
The trustee makes premium payments to cover the cost of the trust, using the Crummey system to facilitate these payments. The ILIT allows for up to $12 thousand, annually, to be transferred to each recipient. The beauty is this is done without incurring any gift tax on the transfer, whatsoever.
The only stumbling block is that the funds need to be transferred as a gift of present interest, not future. Crummey overcomes this by giving each beneficiary the opportunity to withdraw the money within 30 days.
To carry this kind of payment out, a letter must be sent to the beneficiaries, notifying them the money has been deposited. Their grace period to withdraw the funds starts, then.
Regardless of whether they do or don’t (and you’d like to hope they won’t), this money officially exists under present interest. It is exempt from gift taxation under the Crummey Trust Provision.
The Potential Downsides
Of course, there’s no such thing as a perfect solution.
As you already know, one of the first disadvantages to creating an ILIT is that the trust becomes inaccessible to the grantor. This means you’ll forgo your right to funds contained within it.
You also lose control over amendments to the trust, and even the ability to terminate the ILIT itself. If you no longer want the trust, your best option is to instruct your trustee to let your annual payments lapse.
If your policy is valued in cash, instead, designate the funds to pay for its premiums until the funds run out. Since you won’t be able to withdraw the amount, this will simply delay the end of the trust’s life.
The final consideration to make is whether you have enough time left to transfer your existing policy to the trust. If you transfer your insurance to the ILIT within three years before your death, the policy’s proceeds could still be taxed as part of your estate.
This last issue has a solution. If you can afford to pay the premiums, have the trust purchase the life policy and pay it fully over the course of this period. If you’re all paid up, there’s less chance of the funds not being enough to avoid being counted against your estate.
Insure Yourself. Protect That Insurance.
Creating life insurance policies is our way of providing for our loved ones after we’re dead.
There’s no use having one, however, if you don’t safeguard against unexpected losses. As we mentioned earlier, many people don’t know the IRS can include their life policies against their estates after they die. Not knowing won’t stop it from happening, though.
Now that you know, you can take steps to prevent it from happening.
An irrevocable life insurance trust lets you set up finances for your beneficiaries after your death. While relinquishing control over your policy can be scary, the benefits here are obvious.
If you’re going to provide for your family and loved ones after you’re gone, why not make sure they get everything they deserve?
One more word of advice: irrevocable life insurance policies are complicated legal entities. You need to know what you’re doing when you set one up.
The whole purpose is to use the trust to protect your beneficiaries’ insurance payouts against losses. While you’re welcome to set up a trust yourself, why take the risk of leaving out some crucial step and making the whole thing ineffective?
Get in touch with us today, for more information on our life insurance policies, and find out how we can help you.
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