In general, Irrevocable Life Insurance Trusts (“ILITs”) are trusts that are designed to distribute life insurance money to a person’s heirs upon the insured person’s death. An ILIT different from other trusts. ILITs are very difficult to modify and they prevent the insured from having any control over the insurance policy. The insured cannot be a beneficiary of their ILIT nor can the insured be a trustee. By making a life insurance trust irrevocable and preventing the insured from having any control over the life insurance policy, proceeds from the policy can pass the the person’s heirs in a tax efficient manner.
Many financial experts recommend the Irrevocable Life Insurance Trust because it is perhaps the single most tax efficient estate planning technique available to the general population. Many are under the false assumption that the payout on a life insurance passes completely tax free to the beneficiary. While life insurance proceeds are paid out income tax free, it is subject to the federal estate tax. Additionally, the payout on a life insurance policy may be subject to estate and inheritance taxes in some states.
Whether a life insurance policy is subject to the federal estate tax is dependent upon how the policy is owned. Generally, if a person owns a life insurance policy on his or her own life, then the face value of that policy will be includible in the person’s taxable estate. Since the federal estate tax exemption has increased substantially, many people are no longer worried about the federal estate tax. However, if your estate is above the federal estate tax threshold, or you live in a state where there is a state estate tax or a state inheritance tax, an ILIT could substantially reduce the taxes that your heirs must pay.
Creating an ILIT vs. Having Another Person Own the Policy on Your Life
Many advisors will counsel clients that they should have someone other than the insured own the policy rather than creating an ILIT. This strategy can work well for smaller policies and for when there is no danger that the new owner will modify beneficiaries in a manner that would displease the insured. For example, it would never be wise to have only one of three children own a policy on the parent when that new owner can easily change the beneficiary to himself. It would also not be wise for spouses to own large policies on each other because eventually both will die and then there will be a large tax on the death of the surviving spouse.
An ILIT also provides control over a greater period of time. Imagine a situation where Bob wants to leave money to his sister, Jane. However, Bob doesn’t like his sister’s children and wants to make sure that whatever is left when Jane dies goes to his children. If Jane owns the policy on Bob’s life, Bob would have no control over what Jane dies with the money on her death. By creating an ILIT, Bob can guarantee the money goes where he wants, and in a tax efficient way.
Can an ILIT Can Own Assets Besides Life Insurance?
Yes. An ILIT can own property other than life insurance. Since the Grantor has very little control over the trust after it is established, funding an ILIT with assets other than life insurance is not right for everyone. Basically, once you put money into the trust, you are giving up the right to get the money back. However, your heirs can still be current beneficiaries of a Life Insurance Trust. Accordingly, the use of an ILIT can be a valuable asset protection tool for ultra high net worth clients.
An ILIT Can Be a Useful Part of a Special Needs Trust Plan
When creating a Special Needs Plan, an ILIT is often an integral tool. For many people, they are willing to pay for the costs of a special needs child while they are alive. However, they also need to guarantee money will be available on their death. We frequently recommend that clients form a Special Needs Trust within an ILIT as a way to guarantee that a special needs person’s needs are met in a tax efficient manner.
What is a Second to Die Life Insurance Trust?
A Second to Die Life Insurance Trust is designed to hold life insurance policy where both a husband and wife are the insured. A second to die life insurance policy is typically less expensive than a policy on the life of just one person. Since the federal estate tax does not affect most people until the death of the surviving spouse, a Second to Die Life Insurance Trust is a great planning tool for many people.
If you have any questions about trust planning or life insurance trusts, please contact Attorney Kevin A. Pollock, who is the head of the firm’s Trust Planning Department.