Do I Need a Life Insurance Trust?

Do I Need a Life Insurance Trust?

Irrevocable Life Insurance Trusts have three components: a grantor, the person who creates a trust, a trustee, the manager of the trust and a beneficiary or beneficiaries, explains a recent article titled “What is an Irrevocable Life Insurance Trust?” from The Edwardsville Intelligencer.

In an ILIT, the trustee purchases the policy, and the irrevocable trust becomes the owner. When insurance benefits are paid on the death of the grantor, the trustee collects the funds, pays any estate taxes due and any outstanding debts, like legal fees and probate costs, then distributes the rest to beneficiaries.

The biggest reason for people to consider an ILIT is to help lessen estate taxes. In the last few years, the federal estate and gift tax exemption has been set at historically high levels, and most people don’t need to worry about that on a federal level. However, state estate taxes still need to be addressed, and the federal estate tax level is set to drop dramatically in 2026.

There are other reasons for an ILIT:

If a life insurance beneficiary is incapacitated, the ILIT can prevent the court system from controlling proceeds.

Proceeds from the ILIT can provide cash to pay expenses, including estate taxes and any other debts.

The ILIT can provide income for the spouse without the funds being included in the spouse’s estate.

The ILIT can provide protection for heirs. Depending upon the state where you live, proceeds from life insurance payouts may or may not have protection from creditors. Speak with your estate planning attorney to learn if this applies to you.

Ability to include a “Spendthrift Provision.” If an heir or heirs has trouble managing money or is prone to making bad decisions, financial and otherwise, the ILIT trust can contain a spendthrift provision to pay beneficiaries monthly, instead of providing them with a lump-sum payout.

However, the ILIT isn’t for everyone. There are some downsides to consider.

The ILIT is irrevocable, and is difficult, if not impossible, to make changes to it, with the exception of changing the trustee. Once a policy is placed in an ILIT, you give up any rights to the policy. You can’t reassign it to a different trust or any other legal entity.

ILITs are complex and nuanced legal vehicles requiring the help of an estate planning attorney who knows their way around trusts. This has been a very general overview of a topic with many moving parts to it. Discuss whether an ILIT will be useful for your estate plan with an experienced estate planning attorney.

Reference: The Edwardsville Intelligencer (Jan. 31, 2023) “What is an Irrevocable Life Insurance Trust?”

How Does an Irrevocable Life Insurance Trust Work?

How Does an Irrevocable Life Insurance Trust Work?

Irrevocable Life Insurance Trusts (ILITs) are a common planning tool. However, buying the policy at the wrong time, leaving out Crummey withdrawal rights and ignoring administrative costs are commonly made mistakes. Being aware of these snares is important to make the ILIT effective, says a recent article titled “Irrevocable Life Insurance Trusts in Estate Planning: Common Pitfalls” from Think Advisor.

Purchasing a new policy outside of the ILIT is a commonly made error. If you purchase a new life insurance policy and then transfer it to the ILIT, the death benefit will be included in your estate for estate tax purposes if you die within three years of the transfer. This undoes any estate tax advantages of the insurance policy and the trust.

IRS Section 2035 causes estate tax inclusion for anyone who transfers or otherwise gives up power over a life insurance policy within three years of death. However, there are ways to address this. If you first establish and fund the ILIT first, so the ILIT is the entity purchasing the policy directly, the death benefit is excluded from your estate regardless of how long you live after the purchase date.

Another error concerns the “Crummy Protocol.” Unless or until the premiums on a life insurance policy are fully paid or are self-sustaining through a draw on the cash surrender value, the insured must make gifts to the ILIT to pay for the premiums. People often like to use their annual gift tax exclusion to make contributions. However, to qualify the gifts for the annual gift tax exclusion, the beneficiaries of the ILIT must have the right to withdraw certain amounts transferred into the ILIT.

Failing to include the required withdrawal rights may eliminate the ability to offset gifts by the annual exclusion right. Even if the ILIT includes Crummey withdrawal rights, you won’t be able to take advantage of the annual gift tax exclusion if the beneficiaries are not informed of their withdrawal rights each time an eligible contribution is made to the ILIT.

Your estate planning attorney will advise you as to how this occurs from a procedural perspective. You’ll want them to review it before it is signed to confirm it includes Crummey withdrawal rights and to help you establish procedures for providing the requisite notice and waiting the required period each time a gift is made.

Lastly, ILITs often have limited assets since they may only be funded with the insurance policy and the amount needed to pay the premiums. Therefore, if the ILIT has any administrative expenses, like accounting, legal or trustee funds, there may be insufficient assets in the ILIT to pay them.

If you pay the expenses directly, they will be considered as making a gift for gift tax purposes, because you will be deemed to have first transferred to the ILIT any amounts paid on its behalf. Avoid this issue by funding your ILIT with the necessary money to pay premiums and administrative costs. If the class of beneficiaries holding Crummey withdrawal rights is broad enough, this may be done solely through annual exclusion gifts.

Reference: Think Advisor (Sep. 29, 2022) “Irrevocable Life Insurance Trusts in Estate Planning: Common Pitfalls”

What are Benefits of Putting Money into a Trust?

What are Benefits of Putting Money into a Trust?

For the average person, knowing how a revocable trust, irrevocable trust and testamentary trust work will help you start thinking of how a trust might help achieve your estate planning goals. A recent article from The Street, “3 Powerful Types of Trusts that Can Work for You,” provides a good foundation.

The Revocable Trust is one of the more flexible trusts. The person who creates the trust can change anything about the trust at any time. You may add or remove assets, beneficiaries or sell property owned by the trust. Most people who create these trusts, grantors, name themselves as the trustee, allowing themselves to use their property, even though it is owned in the trust.

A Revocable Trust needs to have a successor trustee to manage the assets in the trust for when the grantor dies or becomes incapacitated. The transfer of ownership of the trust and its assets from the grantor to the successor trustee is a way to protect assets in case of disability.

At death, a revocable trust becomes an Irrevocable Trust, which cannot be easily revoked or changed. The successor trustee follows the instructions in the trust document to manage assets and distribute assets.

The revocable trust provides flexibility. However, assets in a revocable trust are considered part of the taxable estate, which means they are subject to estate taxes (both federal and state) when the owner dies. A revocable trust does not offer any protection against creditors, nor will it shield assets from lawsuits.

If the revocable trust’s owner has any debts or legal settlements when they die, the court could award funds from the value of the trust and beneficiaries will only receive what’s left.

A Testamentary Trust is a trust created in connection with instructions contained in a last will and testament. A good example is a trust for a child outlining when assets will be distributed to them by the trustee and for what purposes the trustee is permitted to make the distribution. Funds in this kind of trust are usually used for health, education, maintenance and supports, often referred to as “HEMS.”

For families with relatively modest estates, a trust can be a valuable tool to protect children’s futures. Assets held in trust for the lifetime of a child are protected in the event of the child’s going through a divorce because the child’s inheritance is not subject to equitable distribution when not comingled.

Many people buy life insurance for their families, but they don’t always know that proceeds from the life insurance policy may be subject to estate taxes. An insurance trust, known as an ILIT (Irrevocable Life Insurance Trust) is a smart way to remove life insurance from your taxable estate.

Whether you can have an ILIT depends on policy ownership at the time of the insured’s death. In most cases, the insurance trust must be the owner and the insurance trust must be named as the beneficiary. If the trust is not drafted before the application for and purchase of the life insurance policy, it may be possible to transfer an existing policy to the trust. However, if this is done after the purchase, there may be some challenges and requirements. The owner must live more than three years after the transfer for the policy proceeds to be removed from the taxable estate.

Trusts may seem complex and overwhelming. However, an estate planning attorney will draft them properly and make sure that they are used appropriately to protect your assets and your family.

Reference: The Street (May 13, 2022) “3 Powerful Types of Trusts that Can Work for You”

What is the Purpose of an ILIT?

Life insurance falls into two categories: life insurance and death insurance. Life insurance is used to take advantage of the tax-free returns that qualifying insurance products enjoy under federal income tax laws. There is a death component. However, the main purpose is to serve as a tax-deferred investment vehicle. Death insurance is used to provide financial security for loved ones after the owner passes, with little or no regard for tax and investment benefits.

Using both types of life insurance in estate planning can be a complicated process, but the resulting financial security is well worth the effort, as reported in a recent article “Keeping an Eye on ILITs” from Financial Advisor.

The Irrevocable Life Insurance Trust is a somewhat complex trust structured under state trust law and tax strategies under federal income tax laws. ILITs have been tested in court cases, audits and private letter rulings, so an estate planning attorney can create an ILIT knowing it will serve its intended purpose.

Life insurance in an ILIT is owned outside of the estate and enhances the after-estate tax wealth for the surviving spouse and heirs. Because the trust is irrevocable, the transfer of ownership is permanent.

The annual insurance premium is typically paid by the insured to the ILIT, subject to “Crummey” withdrawal powers, named after a famous case, which gives named people the power to withdraw all or a portion of the contributed premium amounts within specified periods. The time frame depends on the trust—usually it’s 30 or 60 days, but sometimes it’s annually.

There are many nuances and details.  The ILIT lets an insured buy life insurance “outside of their estate” for estate tax purposes, lets the person treat insurance premiums as non-taxable gifts under the annual exclusion provisions and provides safety and security to the beneficiaries.

The ILIT is often used as part of a buy-sell agreement for privately held family businesses to make it possible for the business itself or business partners to buy out the equity of a deceased partner. The payment obligations may be funded by the proceeds from life insurance. In some cases, each partner buys a traditional insurance policy in an ILIT. The estate planning attorney working on a succession plan can provide advice on the most effective way to use the ILIT.

Another use for the ILIT is for wealthy families with illiquid assets, like an art collection or a large real estate portfolio. An ILIT holding a life insurance policy with a death benefit lets the beneficiaries use the proceeds to pay estate tax liabilities, without dipping into their own or the estate’s assets. The investment returns of the ILIT increase the policy owner’s wealth substantially, without increasing their taxable estate.

Reference: Financial Advisor (December 1, 2021) “Keeping an Eye on ILITs”

What Is Purpose of an Irrevocable Life Insurance Trust?
Revocable trust on a wooden desk.

What Is Purpose of an Irrevocable Life Insurance Trust?

Irrevocable Life Insurance Trusts, or “ILITs” are life insurance policies owned by irrevocable trusts used to manage taxes on estates. There are complexities to using an ILIT, but the benefits for some people could be big, according to the article “What Advisors Should Know About Irrevocable Life Insurance Trusts” from U.S. News & World Report.

What is the goal of an ILIT? The goal of an Irrevocable Life Insurance Trust is to own a life insurance policy, so the proceeds of the policy are left to heirs, who avoid estate tax. It’s a type of living trust but one that cannot be dissolved or revoked, unless the trust does not pay premiums and the insurance policy owned by the trust lapses.

The federal estate tax exemption is currently $11.58 million for individuals, and $23.16 for married couples. Most people don’t need to worry about paying federal estate taxes now, but this historically high level will not be around forever. The current law ends in 2025, cutting the exemption by half. If Congress needs to raise revenue before then, change could come sooner.

Who needs an ILIT?

The main advantage of an ILIT is providing immediate cash, tax free, to beneficiaries. The value of the ILIT is out of the estate and not subject to taxable estate calculations. The life insurance policy ownership is transferred from the insured to the trust. The insured does not own or control the insurance policy, but this is a small price to pay for the benefits enjoyed by heirs.

The grantor is the insured person, and the policy is purchased with the ILIT as the owner and the beneficiary. The insured cannot be the trustee of the trust. In most cases, the trustee is a family member, and the insurance premiums are paid through annual gifting from the insured to the trust. These are the details that should be explained by an estate planning attorney to maintain the trust’s legitimacy.

If all goes as planned, when the insured dies, the ILIT distributes the life insurance proceeds tax-free to beneficiaries.

How does an ILIT work?

Let’s say that you have assets worth $15 million. You buy a life insurance policy that will pay $5 million to your children. When you die, your taxable estate would be $20 million, which in 2020 would incur about $3.3 million in federal estate taxes. However, if you used an ILIT and the ILIT owned the $5 million policy instead of you, your taxable estate would be $15 million. Your federal estate tax in 2020 would be about $1.3 million. The estate would save $2 million simply by having the ILIT own the $5 million life insurance policy.

What if the estate tax exemption goes down before you die?

If the estate tax exemption goes down and you have already funded the ILIT, it remains safe from estate taxes. Here is another reason to consider an ILIT—as long as the funds remain in the trust, they are safe from beneficiary’s creditors.

Are there any downsides to an ILIT?

ILITs are not do-it-yourself trusts. They are complex and need to be structured so that the annual contributions used to pay the insurance premiums qualify for the $15,000 gift tax exclusion. To do this, an estate planning attorney will often include a “Crummy” power, which allows the insured to pay the trust for the premium, without reducing their lifetime gift tax exemption amount. However, it also means that beneficiaries need to be well-educated about the ILIT, so they don’t make any errors that undo the trust.

When a contribution is made, Crummey letters are sent to the beneficiaries, letting them know that a gift was made to the trust and they have the right to withdraw the money. However, if they withdraw the money, the insurance policy could collapse.

You’ll need to be committed to keeping this policy for the long run. You’ll need to be able to fund it appropriately.

There is also a three year look back for existing insurance policies that are moved into the ILIT, so the grantor must be alive for three years after the policy is given to the ILIT for it to remain outside of the estate. This does not apply when a new policy is established in the ILIT and does not apply if the ILIT buys the policy from the grantor.

Reference: U.S. News & World Report (Oct. 29, 2020) “What Advisors Should Know About Irrevocable Life Insurance Trusts”

Different Trusts for Different Estate Planning Purposes

Different Trusts for Different Estate Planning Purposes

There are a few things all trusts have in common, explains the article “All trusts are not alike,” from the Times Herald-Record. They all have a “grantor,” the person who creates the trust, a “trustee,” the person who is in charge of the trust, and “beneficiaries,” the people who receive trust income or assets. After that, they are all different. Here’s an overview of the different types of trusts and how they are used in estate planning.

“Revocable Living Trust” is a trust created while the grantor is still alive, when assets are transferred into the trust. The trustee transfers assets to beneficiaries, when the grantor dies. The trustee does not have to be appointed by the court, so there’s no need for the assets in the trust to go through probate. Living trusts are used to save time and money, when settling estates and to avoid will contests.

A “Medicaid Asset Protection Trust” (MAPT) is an irrevocable trust created during the lifetime of the grantor. It is used to shield assets from the grantor’s nursing home costs but is only effective five years after assets have been placed in the trust. The assets are also shielded from home care costs after assets are in the trust for two and a half years. Assets in the MAPT trust do not go through probate.

The Supplemental or Special Needs Trust (SNT) is used to hold assets for a disabled person who receives means-tested government benefits, like Supplemental Security Income and Medicaid. The trustee is permitted to use the trust assets to benefit the individual but may not give trust assets directly to the individual. The SNT lets the beneficiary have access to assets, without jeopardizing their government benefits.

An “Inheritance Trust” is created by the grantor for a beneficiary and leaves the inheritance in trust for the beneficiary on the death of the trust’s creator. Assets do not go directly to the beneficiary. If the beneficiary dies, the remaining assets in the trust go to the beneficiary’s children, and not to the spouse. This is a means of keeping assets in the bloodline and protected from the beneficiary’s divorces, creditors and lawsuits.

An “Irrevocable Life Insurance Trust” (ILIT) owns life insurance to pay for the grantor’s estate taxes and keeps the value of the life insurance policy out of the grantor’s estate, minimizing estate taxes. As of this writing, the federal estate tax exemption is $11.58 million per person.

A “Pet Trust” holds assets to be used to care for the grantor’s surviving pets. There is a trustee who is charge of the assets, and usually a caretaker is tasked to care for the pets. There are instances where the same person serves as the trustee and the caretaker. When the pets die, remaining trust assets go to named contingent beneficiaries.

A “Testamentary Trust” is created by a will, and assets held in a Testamentary Trust do not avoid probate and do not help to minimize estate taxes.

An estate planning attorney in your area will know which of these trusts will best benefit your situation.

Reference: Times Herald-Record (August 1,2020) “All trusts are not alike”