The Financial Advantages of Using an ILIT
While trusts tend to have the “oh, that’s for rich people” stigma, nothing could be further from the truth. Trust funds aren't just for rich people. Trusts can be incredibly useful to many people, regardless of financial means, and for any number of different purposes.
For instance, have you heard of a life insurance trust? An Irrevocable Life Insurance Trust (ILIT) can provide a number of legal and financial advantages to your heirs. Your life insurance policy could be one of the greatest assets your estate has after you pass away, but the life insurance payout comes with some strings that an ILIT can improve.
What is an ILIT?
An ILIT is an irrevocable trust that is funded by a life insurance policy for the person who set up the trust. It can either be set up by an individual or jointly by a couple (a second-to-die life insurance policy), but the death benefit for a second-to-die policy will not be paid out until the surviving spouse passes.
When the person or persons who set up the trust pass away (the grantors), then the proceeds from the life insurance policy are paid into the trust and distributed to trust beneficiaries, either in a lump sum or incrementally depending on the specifics of the trust and the judgment of the trustee.
Why Use an ILIT
There are a number of reasons to set up an ILIT instead of just having a life insurance policy that is paid to a named beneficiary. ILITs can give your heirs more flexibility in managing or settling an estate, can help them avoid high estate or inheritance taxes, and can even protect the benefits of heirs who receive government benefits and protect insurance death benefits from creditors.
1. Tax benefits
If an ILIT is set up and administered correctly, the beneficiaries may be able to avoid paying estate and inheritance taxes on the life insurance death benefit. The federal estate and gift tax exemption is currently at $5.49 million—most estates including life insurance policies do not reach that amount. But a number of states begin taxing your estate at $1 million or less.
A $1 million estate is easy to arrive at if you have a $700k life insurance policy and a property worth $300k. So separating your life insurance benefit from your estate by putting it in an ILIT can potentially help your heirs avoid estate taxes (the top federal estate tax rate is 40%; state taxes vary).
2. Gift tax exemption
If done properly, contributions to the trust, such as payment of premiums, are considered gifts to beneficiaries and qualify for the annual $14k gift exclusion, which avoids having to file gift tax returns at death.
To qualify, you must use a “Crummey letter” (named for a famous tax case) to notify beneficiaries of the trust of their right to withdraw a share of their contributions for 30 days. After 30 days the trustee can use contributions to the trust to pay policy premium.
3. GST tax exemption
With an ILIT, there’s another estate tax you can be exempt from: the generation-skipping transfer tax (GST). The GST imposes a 40% tax on outright gifts and transfers in trust to relatives more than a generation younger than the donor or to unrelated persons who are more than 37.5 years younger than the donor.
If you want the proceeds from your life insurance to be distributed to your family, possibly across multiple generations, having an ILIT will remove the proceeds from your estate and exempt proceeds from the GST.
4. Flexibility in managing the estate
Another advantage is that having liquidated assets from the life insurance payout that are exempt from inheritance taxes can give your heirs flexibility in managing the estate. Heirs often have trouble paying estate taxes because of lack of access to cash and can be forced to sell estate assets in order to raise cash.
Being able to use the proceeds of a life insurance policy can allow your heirs to settle the estate without having to sell the family home.
5. Protect government benefits of an heir
If you have an intended beneficiary that receives government benefits, such as Social Security Disability or Medicaid, distributing a life insurance payout to them in a lump sum may disqualify them from continuing to receive those benefits.
An ILIT would allow the trustee to make incremental distributions of the proceeds and thus protect your intended beneficiary’s benefits.
6. Protection from creditors
Lastly, having an ILIT can help ensure that your heirs can receive life insurance proceeds free of any claims that their creditors may have on them because distribution of proceeds can be left to the discretion of the trustee.
This can allow you to offer some degree of protection to your heirs if they need it.
Some Things to Consider
There are some other things to take into consideration before setting up an ILIT—it’s not necessarily an easy solution to the issues mentioned.
For starters, setting up an ILIT can be complex. If it is not properly drafted, you may not get the benefits you are hoping to get. There are strict drafting and procedural guidelines that must be met in order to conform to IRS guidelines.
Also, the ILIT is an irrevocable trust. That means that once it is set up and funded, you step away and let the trustee handle everything. You cannot modify it or withdraw assets from it. If this doesn't fit your situation, a revocable living trust might make more sense.
But those precautions aside, an ILIT can be a powerful estate and wealth management tool and can ensure that your heirs get the intended benefit from your policy.