An irrevocable life insurance trust is a non-amendable legal structure that is the sole owner and beneficiary of a life insurance policy where, upon the death of the insured party, the death benefit is paid to the trust and invested on behalf of the beneficiaries of that trust.
Introduction To Irrevocable Life Insurance Trusts
It is strange to admit, but life insurance is among the few investments we make primarily due to the fear we have of the unknown. How would our loved ones cope with our untimely demise? Could they return to work right away, pay for life’s expenses, and retire with dignity without us supporting them? Would the unexpected loss of income, grief, and lack of emotional stability cause them to live a life of poverty and missed opportunity? There is no way to know for certain how those closest to us would react to our passing, but life insurance can act as a cornerstone to an intelligently crafted estate plan. It may not be able to replace our physical presence, but it can replace lost income and ensure that those we love are empowered by our memory, rather than financially burdened by our passing.
Estate planning would be degrees of magnitude easier if the challenge of providing for our families after our passing was as simple as buying a well funded insurance plan and ensuring that our children and spouse were designated as beneficiaries. While that simple transaction may work well for adult children and spouses who are confident with financial management and their ability to make sound financial judgments in the most challenging of times, what is someone to do when they have a special needs adult child, a disabled spouse, a large estate, are facing liabilities at the time of your demise, or have complex final plans that require more than the stroke of a pen to see fulfilled?
An irrevocable life insurance trust (“ILIT”) may be the most efficient way to support your family members, protect your assets, and ensure that your years of sound financial planning are honored through continued diligent management. Changes in recent laws make ILITs easier than ever before to establish and the advancements in low fee investment options are making them an obvious choice for breadwinners who simply will not tolerate unacceptable levels of risk.
What Is An Irrevocable Life Insurance Trust?
An irrevocable life insurance trust provides estate planners more control than ever before over the money that insurance companies pay out at the time of their death. They also insulate your heirs from your debts, judgments, and estate taxes that may be due at the time of your passing. Simply put, ILITs guaranty that the assets you’ve worked your entire life to set aside to support your loved ones are available to provide ongoing stability and support at the time of their most pressing and substantial needs. For caregivers of family members who are facing special needs and are accepting Medicaid and other means based government benefits, ILITs also ensure that your family members can continue to receive state funded care while enjoying their inheritance.
How Are ILITs Established?
An ILIT requires the creation of a three party relationship. First, you serve the role as the “grantor.” You are purchasing life insurance policies and establishing the trust relationship. In creating a trust relationship, you are designating a “trustee” whose responsibility is to manage the trust. A trustee is the second person involved in this relationship and they will be bound to execute the terms of the trust according to the terms of the trust documents that you create. They will process insurance claims upon your passing and will distribute the insurance proceeds to your designated beneficiaries in accordance with the terms of your trust. They are responsible to you and to your beneficiaries and must be bound by your directions while acting in the best interest of your heirs. Put more plainly – a trustee is required to respect your wishes and to ensure that the assets of the trust are used wisely to benefit your family members.
The final person involved in the ILIT relationship is the beneficiary. These are the people who get the money when you die. You must be extremely careful in designating a beneficiary because if you name your estate as a beneficiary, you will expose the money to estate taxes, probate fees, and other avoidable costs.
To create an ILIT, you (the grantor) need to purchase a life insurance policy that insures your life. Rather than naming your family members as the beneficiaries, you will name the trust as the owner and also the beneficiary. Upon your passing, the benefit will be paid out to the trustee. Your trustee will be authorized to pay out foreseeable expenses associated with your passing. This includes expenses like estate taxes and burial fees. After these costs are paid off, your trustee will distribute or invest the remaining money to your beneficiaries in accordance with the terms of your trust.
What Makes An ILIT “Irrevocable”?
Unlike living trusts, irrevocable trusts cannot be changed or modified by the grantor or trustee once the trust relationship is established and the policy is funded. You are free to determine who your initial beneficiaries will be, to define the terms that will cause them to receive payments, and assign trustees to manage the ILIT. What are you buying with this loss of control? Irrevocable trusts reduce risk and ensure that your wishes are fulfilled. Because an ILIT is a legal entity that is completely separate from the grantor (you), a tax lien, civil judgment, or unsatisfied debt in your name cannot diminish or eliminate your beneficiaries’ inheritance that passes from the ILIT. For high net worth individuals, the added advantage to an ILIT is that assets passed through the ILIT are not counted as part of the estate, are not subject to probate taxes, and do not add to the estate tax basis.
Who Should Use An ILIT?
ILITs are suitable for those who have a high net worth, specific estate plans, special needs family members, or are generally adverse to any kind of avoidable risk. Anything that is placed in the name of the deceased at the time of their death will enter into their estate and be subject to the probate process and all of the fees, delays, and taxes associated with that. People who designate their estates as their life insurance beneficiaries may subject that money to avoidable estate taxes and probate fees that could be avoided simply by designating an ILIT or independent person as the beneficiary. This is especially important for high net worth individuals as their failure to use an ILIT may expose their life insurance proceeds to nearly confiscatory tax ILITs support specific estate plans because the trust documents govern precisely when and who receives payments from the trust. Whether you would like to reward your child upon the birth of your first grandchild, establish a college fund for your unborn grandchildren, or terminate payments for people who are acting immorally or criminally; ILITs afford you a right to control the disposition of your money that is lacking in traditional estate planning mechanisms. Your trust, when properly drafted, ensures that those who benefit from your life’s hard work and savings live and act according to your personal values.
For those with special needs family members, ILIT trusts can confer a degree of dignity that is otherwise incredibly hard for them to secure. An ILIT can be used to support a higher quality of life than would otherwise be possible for a special needs family member who is receiving means based government aid. An adult child receiving Medicaid benefits may not be able to inherit the proceeds of a $1M life insurance policy without being disqualified from Medicaid benefits. This disqualification has the effect of requiring your policy to be used to fund the same benefits your family member was receiving through state funding until your money is gone. An ILIT keeps the money out of your family member’s name and allows the trustee to directly fund life expenses like vacations, reasonable entertainment, long term care that is not covered by Medicaid, and housing while preserving benefits eligibility.
Part of estate planning is about reducing our exposure to risk during vulnerable times. ILITs place the proceeds of what are oftentimes enormous life insurance policies into a legally independent entity. The liabilities accrued in our name or in the names of our heirs will not disturb the assets placed into the ILIT. Because the ILIT does not do anything independently, it is very unlikely that it would be a valid target for a lawsuit. As a result of their independence and resilience to legal action, ILITs should make up part of the estate plan for anyone who is risk adverse or concerned about legal exposure from civil actions.
Children and ILITs
ILITs should fill a special role in the estate planning of any young family. If you have young minor children at the time of your passing who are designated as life insurance beneficiaries, the life insurance company cannot legally pay your benefit directly to your children. Instead, the insurance company will need to start a court action and request that the court appoint a special guardian to oversee the money for the child. This is done to ensure that the money is not squandered or stolen by adults who are involved in the child’s life. You can safeguard your child’s financial future and avoid the delays and court fees associated with a guardianship process by using an ILIT.
An ILIT will necessarily require that an adult trustee supervise your children’s money and invest it in accordance with your wishes. The money will not be paid out to your children until a time of your choosing. The alternative would be to establish a Uniform Transfers to Minors Act (UTMA) account. These accounts may be cheaper to establish, but they require that your minor child receive all of their inheritance money at the time of their 18th or 21st birthday. For particularly large inheritances, it would be simply irresponsible to transfer so much money to young and inexperienced investors. UTMA transfers also take place irrespective of personal misconduct or irresponsibility. An ILIT allows you to protect your child’s inheritance from themselves.
Effective ILIT Creation
For all of the benefits they confer, you might expect ILITs to be highly sophisticated legal entities that are expensive and complicated to establish. Realistically, nothing could be further from the truth! The very first step to establishing an airtight ILIT is to find a trusted estate planning attorney. While there are do-it-yourself packages available on the internet, the consequences of imperfect trust formation can be enormous and are entirely avoidable. Having an expert help guide you on this path is well worth the $1,000 – $4,000 an irrevocable trust typically costs to establish. When considering the value of life insurance policies, this is a minor price to pay to shield assets that are likely going to exceed a combined death benefit of a million dollars.
Once you’ve found your attorney, you will need to name your intended beneficiaries. Beneficiaries do not need to be people. You can establish charitable organizations, schools, and even pets as beneficiaries, provided that you take certain steps specific to your state’s laws. After identifying your beneficiary, you will need to appoint a trustee and establish the terms that will govern when that trustee makes payments to your beneficiary from your ILIT.
When deciding how you want your beneficiaries to be paid, you do not need to treat each beneficiary the same. You could decide that one charity is to receive a certain amount of money each year, while another charity gets a single lump sum at the time of your passing. You could allow one child to receive their money upon their college graduation and another child to receive theirs when they buy their first home. You can also empower your trustee to make disbursements when your beneficiaries request additional money for special purposes. Whether this is starting a business, taking a vacation, or funding unique medical treatment is entirely up to you and your estate plan.
In the event that you do not expect all of your life insurance proceeds to be paid out shortly after your death, your ILIT should also contain investment guidance for your trustee. To avoid long term opportunity costs, directing your trustee to invest your death benefit to protect against inflation and market action is highly advisable and is something a competent advisor can assist you with.
Selecting Trustees for ILITs
What should be considered when deciding who should serve as your trustee? Unlike living trusts, you and your spouse cannot serve as your own trustees. If you were to designate your spouse or yourself as the trustee, the IRS could determine that you exercised excessive control over the irrevocable trust and deem that the trust is really your alter ego. That will open the trust to liability and expose it to avoidable estate taxes. To ensure that this outcome does not befall your trust, you will need to appoint a neutral and detached third party to serve as your trustee. But who makes the best trustee?
Before answering that pressing question, you need to appreciate what exactly it is that the trustee does. A trustee’s primary responsibility is to manage your ILIT for you, on your behalf, and in accordance with the guidance you’ve established in the trust documents. While you are alive, your trustee will take funds from the ILIT that you transfer each year to pay for the insurance premiums. Upon your passing, the trustee will notify the insurance companies, collect the death benefits, and distribute or invest the policies’ proceeds according to your specific direction.
ILITs allow grantors a wide degree of latitude in deciding what kind of insurance to place inside of an ILIT. Whether you would like to use an individual life policy that only insures a single person, a survivorship policy that insures you and your spouse, whole life insurance or term life insurance is entirely up to you. All that matters is that anyone named as a beneficiary to a life insurance policy cannot serve as the trustee and you cannot pay for the policy’s premiums outside of the ILIT.
Deciding who shall serve as a trustee is a critical decision, because you need to inherently believe that the person you appoint will follow your direction to the letter. If you have a trusted family member or friend you hold in confidence, they would likely make a great choice for trustee. Various trust companies and attorneys will also serve as trustees for a small annual fee. If you expect that there may be disputes over the terms of your ILIT’s distribution schedule, the beneficiaries identified in your ILIT, or any other conflict relating to your estate planning documents, using a professional trustee is often recommended.
How Are Annual Premium Payments Made?
Most grantors are required to transfer enough money into their ILITs to pay normal annual insurance premiums. Once the cash transfer is made, the trustee will remit the payments to the insurance carrier. Although the process sounds simple enough, grantors need to ensure that they are complying with IRS gift tax guidelines to avoid gift taxes.
The rules for gifting are fairly straightforward. According to the 2017 annual gift tax exclusion, taxpayers may gift an individual up to $14,000 per year without any gift tax exposure. A married couple is free to make a combined gift of up to $28,000 per year to any one individual and there is no limit to the number of individuals a person can make a gift to. In the event that your premiums exceed the $14,000 for individuals and $28,000 for couples threshold, you will simply need to file a claim against your lifetime estate tax exemption. This will allow you to give up to $5.49MM away during your lifetime without facing any additional taxes as of 2017.
Funded Versus Unfunded ILITs
Do options exist for grantors who do not want to make annual premium payments to their ILITs? Yes, they can establish a funded ILIT. The majority of ILITs are unfunded. That is to say that the grantor will need to transfer funds to make premium payments at regular intervals. A funded ILIT differs from an unfunded ILIT in that the ILIT holds not only the insurance policy, but also an independent income producing asset. Whether this is stock, a royalty producing mineral right or some other asset is immaterial. What does matter is that the income from the independent investment is used to fund at least part of the insurance premiums.
Funded ILITs are uncommon because any income generated by the investment in the trust creates an immediate tax burden that must be paid by the grantor due to the IRS’s application of IRC 677(a)(3). For high net worth individuals and those with high W2 earnings, this may result in a significant tax burden. There are also substantial costs associated with conveying the income producing assets into the trust. Because these assets would typically be substantial, a grantor would either need to make many $14,000 transfers under their annual gift exclusion or would need to claim the transfer against their lifetime exemption. While funded ILITs are something to consider, they may not be right for you.
Additional ILIT Requirements
Once the ILIT is established, an insurance policy is assigned to the policy, and premiums are paid, there are very few additional steps that need to be taken to ensure that the ILIT remains effective. When premiums are paid, your trustee is required to mail out a “Crummey Letter,” which notifies your beneficiaries that the insurance policy premiums were paid into the trust. The trustee is required to wait a time proscribed by law to allow the beneficiaries of the ILIT to withdraw the premium payment. If they do not withdraw that payment, the money is sent directly to the insurance company. Your ILIT will also need to be assigned an independent tax ID number, will operate with a unique bank account in most situations, and may need to file a gift tax return. If you have a fully funded whole life or permanent life insurance plan that is generating a profit from its investments, you may also need to file an income tax return in the name of the ILIT. Speaking with a CPA or estate planning attorney about these additional requirements is always a good idea.
Terminating an ILIT
Terminating an ILIT is as simple as missing insurance payments. Depending on the terms of your policies, your policy may lapse as soon as an annual premium payment is missed. For cash value policies, a missed payment is likely to result in the equity of your policy being used to cover the policy payments until the equity is exhausted. The one thing you cannot do is directly transfer a policy owned by an ILIT into your own name. If you would like to retain the flexibility of tapping into a cash value life insurance policy’s equity for retirement or other purposes down the road, you should consider either funding an independent policy for your ILIT or foregoing the strategy altogether.