What is an Irrevocable Life Insurance Trust?

An irrevocable life insurance trust is a legal document set up to distribute life insurance proceeds in a specific manner, depending on how the trust is designed.  Also known as an “ILIT”, the trust receives special tax consideration from the IRS that is not given to life insurance policies that would otherwise be owned by a natural person or revocable trust.  Since the trust is irrevocable, the terms of the trust cannot be changed – it is “set in stone.”  An ILIT can offer many substantial advantages to protect life insurance proceeds.  It can also help you distribute your property to your children at the least possible cost.

Why Should I Create an Irrevocable Life Insurance Trust?

The IRS code permits a unified tax credit to pass a certain value of property without having to pay a tax.  When you exceed that value (a taxable estate), a massive tax is applied that must be paid within 9 months of death.  If the decedent is single, the tax is due accordingly.  If the decedent is married, the tax is due after the second death (death of the spouse).

If you have a taxable estate, you have a choice.  If you pay the tax with your own money, you are using 100% of your own money with after-tax dollars to pay a second tax.  The choice is to pay the tax with your money, or to pay only a fraction of the tax and use someone else’s money to pay the rest.

If you want to use someone else’s money to pay the tax, you can purchase a life insurance policy.  The type of life insurance policy will depend on the specific circumstances, but is usually a survivorship universal life insurance policy if used for estate tax purposes.  The life insurance policy may be secured for pennies on each dollar of tax that you owe.  By putting the life insurance policy in an irrevocable trust, the proceeds become available to pay taxes due upon death.

A life insurance policy that you purchase will require the same premium whether you put the policy in the trust or keep it outside of the trust.  If you put the policy in the trust, the death benefit is not included in the calculation of the size of the estate.  This is a huge tax savings, especially if the proceeds are several million dollars.  If you keep the policy outside of the trust (e.g., as owned by a natural person or a revocable trust), the proceeds will be included in calculating the size of the estate – you may have inadvertently jacked up the size of the estate, and you may therefore have to pay much higher estate taxes before any of the property can be distributed to your children or other beneficiaries.

Why Not Just Pay the Estate Tax?

Think of the process this way.  A tax is, by nature, a redistribution of wealth.  If you pay the tax out of your own pocket, you are sharing your wealth with all 300 million people of the United States.  If you let the insurance company help pay the tax, you are sharing your wealth with your own family instead.  The cost to share your wealth with 300+ million people is the cost of the tax out of your pocket – the cost to share your wealth with your own family is the premium at pennies on the dollar.

Many people who are seen as “rich” by the government because they have a large estate may not necessarily have a lot of liquid assets.  They may have millions of dollars worth of property that are included in the estate valuation which the estate tax is levied upon, but their heirs or beneficiaries do not necessarily have the money available to pay the tax in full.  To pay the tax (which is due within 9 months of death), they would have to sell off some of the property, potentially at a much lower amount than its true value (think about the real estate market crash in 2007).

As an example, someone with $50 million worth of real estate and $2 million in liquid assets would be required to pay an estate tax of upwards of $25 million, depending on the tax code in place at the time of death.  The heirs would need to sell about $25 million of the real estate at a big discount to be able to pay the tax – of course, this could be avoided by having a life insurance policy for $25 million in place before death within an ILIT, and the premiums would cost much less than $25 million.  These numbers are not exact, but help illustrate the purpose of owning a life insurance policy to help pay the estate tax.

Who Oversees an Irrevocable Life Insurance Trust?

Use of an ILIT relies on the assumption that the children will agree to leave the money alone (that is gifted to them) so the premiums can be used to pay for the coverage.  If one or more of the children decide to do otherwise, the other children must make up the difference or the policy may lapse.  Of course, the children that didn’t use the money to pay the premiums will still be owners of the policy and still receive proceeds upon death.

If an irrevocable trust is deemed to be the best approach, you can design the trust to pay the proceeds as desired, but still use any or all of the children as trustee.  You can also use your attorney, accountant, relative, close family friend, or even an institution (e.g., a bank) to serve as an impartial trustee.

How Much Money Can I Gift Into an Irrevocable Life Insurance Trust Each Year?

You can currently gift up to $13,000 per year per person, or a $26,000 total gift between husband and wife.  You must notify each person that is designated as a beneficiary (through a “Crummey” letter) that a gift has been made and that they have the right to withdraw the money and use it as they please.  The trustee of an irrevocable life insurance trust may set up a bank account to accommodate the gift, and there is usually a time limit for the withdrawal option (e.g., 30 days).  If the gift is left intact, the trustee has enough money at the expiration of the 30 day period to pay the premiums for the policy, and the coverage remains in force.  This process is repeated each year until both insureds are deceased.

Upon death, the trustee of the ILIT receives the proceeds from the life insurance policy, and the trustee can buy the assets from the estate with the cash that has now been paid.  The estate pays the taxes with the cash received from the trustee, and the trustee may now distribute the assets that have been purchased to the designated beneficiaries (children).  The beneficiaries may also receive any excess property left over in the estate as provided in the will.

In short, there is a proven process in place to create substantial leverage for the distribution of property to the children.  The process takes a little more effort, but it can save you hundreds of thousands, even millions of dollars in taxes assessed against the estate.

How Can I Get a Quote for Life Insurance to Pay the Estate Tax?

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