Most of us understand the importance of providing for loved ones using life insurance. However, did you know that if you’re not careful, leaving life insurance money to heirs can result in a significant tax hit? A recent article from The Motley Fool, “What’s an Irrevocable Life Insurance Trust and Why Do I Need One?” looks at some of the benefits of using this more advanced estate planning technique.
So, what is an Irrevocable Life Insurance Trust (or ILIT)? This type of trust is designed to hold a life insurance policy and any cash you may need to pay the premiums on the policy. You can work with an experienced estate planning attorney to set up this trust, fund it with enough cash for the initial premiums and the trust will purchase the policy. While you are named as the insured, the asset—the life insurance policy—is owned by the trust, not by you. That means the death benefit isn’t included in your estate for estate tax purposes.
During life, most people set up an ILIT to receive payment for the premiums using the annual gift tax exclusion amount of $14,000 per year. However, because of the lifetime $5.49 million cap on gifts, if you’re planning on using a gifting strategy or to contribute to charities, you may need to work with an estate planning attorney to determine the best options for you and your estate.
For this type of trust to work, you’ll need to avoid something called “incidents of ownership.” If you’re not careful, incidents of ownership will put the death benefit back into your taxable estate. Some examples of incidents of ownership would be:
- the right to take out a loan against the policy;
- the right to change the beneficiaries on the policy;
- the right to change the way the death benefit is distributed out of the trust.
The benefit of using an ILIT is that you can put in place trustees to determine how trust assets are passed to beneficiaries. Depending on how you decide to set it up with your estate planning attorney, the trust can invest the death benefit to provide for the future needs of the trust beneficiaries. Especially if you’re concerned about life insurance money going to a young child or an irresponsible heir, placing this asset into a trust can protect both the value of the death benefit and the heir from themselves.
You will want to coordinate with an insurance professional as well when creating an ILIT. With certain types of insurance, there could be a liability risk for the trustee. Plan with the advice of an insurance professional to minimize that risk, and to ensure that the cost of the premiums won’t become prohibitively high.
When executed effectively—and when the life insurance is correctly titled in the name of the trust—an ILIT provides the potential for thousands or up to millions of dollars in estate tax savings. Talk to experienced estate planning and insurance professionals to see if this could be a helpful option for your estate plan.
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Reference: The Motley Fool (August 24, 2016) “What’s an Irrevocable Life Insurance Trust and Why Do I Need One?”