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The Irrevocable Life Insurance Trust

Life insurance is among the most common financial products bought in America. It provides consumers with an invaluable and cost-effective source of funds for loved ones. These funds may be used to replace a breadwinner's earnings, to ensure an important family goal (like a college education), or to cover burial costs or unpaid taxes.

Yet, unless we exercise care, life insurance can create as many estate planning problems as it solves.

Enter the Irrevocable Life Insurance Trust (ILIT)

Like most trusts, is simply a holding device. It owns your life insurance policy for you, removing it from your estate. As its name suggests, the Irrevocable Life Insurance Trust is irrevocable. That means once you've created it and placed an insurance policy inside it, you can't take the policy back in your own name.

But you can closely control many other aspects of the ILIT. You can dictate who your initial beneficiaries will be and define the terms under which they will receive benefits. You can choose the Trustee (or Trustees) who will manage your ILIT.

An ILIT provides you, your loved ones, and your estate with considerable advantages. But these benefits can only be achieved if the ILIT is designed properly and specific guidelines are followed carefully.

What estate planning problems can life insurance create?

Everything owned in our name at death is includable in our estate by the government for estate tax purposes. That includes the death benefit proceeds of our life insurance policies. When you consider that policies often provide death benefits in the hundreds of thousands of dollars, it's easy to see how a life insurance policy may have a significant impact on our estate tax liability. There's another estate planning problem that life insurance may create.

An essential part of wise estate planning is deciding not only who our heirs will be, but also how, when, and why they will receive our legacy. Remember, though, that life insurance provides an immediate and often considerable payout of cash to your beneficiaries. And that can create many problems. Even adults with experience managing their finances may find that the sudden windfall of money from your life insurance policy is overwhelming.

How can the ILIT help solve these problems?

The ILIT is an effective tool for addressing many estate planning problems. Here are some of the benefits an ILIT can help you achieve:

  • It will reduce the size of your estate, and thus your estate tax liability.
  • I may reduce the amount of insurance coverage you need, since your estate tax bill will be lower.
  • It will help you protect the cash value of your life insurance policy from creditors.
  • It will allow you to control, when, how, and why your beneficiaries receive the proceeds of your policy.
  • It will help you protect the benefits of a beneficiary who is on government aid.

What other estate planning issues should we be aware of?

If your beneficiary is a recipient of benefits under a government program, such as Medicaid, for example, then the proceeds from your life insurance policy could make your beneficiary ineligible for further benefits. Without careful planning, your beneficiary will have to use up the policy's proceeds on basic needs, and will only be eligible for government benefits once all the money from your life insurance has been spent. This issue isn't just a concern for elderly beneficiaries. Any beneficiary now on Medicaid, or a similar government aid program, is also at risk.

For these beneficiaries, you'll want to control ownership of the life insurance policy's proceeds and manage how they are spent. For example, you won't want your beneficiary to own them outright. In addition, the proceeds shouldn't be used to buy food, shelter, or clothing for your beneficiary. But they can be spent on you beneficiary's education, entertainment, vacations, a home health aide, or other medical treatment or expenses that Medicaid---or some other government program---doesn't cover.

If we own a cash-value life insurance policy in our names, can creditors seize it?

Possibly. In some states, creditors can seize all the cash value of a life insurance policy you own in your own name to settle a claim they may have against you. In other states, however, part or all of your cash value may be protected.

What's required to set up an ILIT?

The process will begin when you sit down with an attorney to design your ILIT. You will

a) Name your beneficiaries;

b) Name your Trustees; and

c) Lay out the circumstances you'll want your beneficiaries to receive money from the ILIT.

What conditions can we establish for policy distributions after our deaths?

It's really up to you. You can, for instance, have the policy's proceeds paid out immediately to one or all of your beneficiaries. Or you can specify that your beneficiaries receive monthly or annual distributions. You may even dictate that beneficiaries receive money when they attain certain milestones. For example, you can provide for a large distribution when a beneficiary graduates from college, buys a first home, marries, or has a child. You can also build in flexibility, so that your Trustee has the discretion to provide distributions when your beneficiary needs it for a special purpose, such as starting a new business, or even a once-in-a-lifetime investment opportunity.

If your beneficiary is on government aid, your Trustee can carefully control how distributions from your policy are used in such a way as not to interfere with your beneficiary's eligibility to receive government benefits. The point to remember is this: You have the opportunity to carefully control how, when, and why your beneficiaries receive the proceeds of your life insurance policy. That gives you the power to ensure that your policy is used in the best possible way on behalf of your loved ones.

Who are typically named as beneficiaries?

The choice is completely up to you, although most people name their children, grandchildren or other close family members.

Who should serve as our Trustee?

With many types of trusts, it's perfectly fine for you or your spouse---or both of you---to serve as your own Trustees. But that's not the case with the ILIT. If you or your spouse are an insured of a life insurance policy that is owned by an ILIT, and you also serve as the Trustee of the ILIT, then the IRS may decide that the policy hasn't left your estate after all. Instead, the IRS may count it as part of your estate, which can impact your estate tax liability.

What does the Trustee do?

The Trustee manages the ILIT for you on your behalf. Your Trustee will follow your directions, as you've initially set forth in the ILIT's documents. While you and your spouse live, your Trustee will take the money you transfer to the ILIT each year and use it to pay your insurance premiums. Your Trustee may also oversee such administrative duties as the annual notification to your beneficiaries (called a "Crummey Letter"), and the filing of the ILIT's tax return, if necessary. Once you've passed away, your Trustee will oversee distribution of the policy's proceeds, according to the directions you've provided.

So we select life insurance policy after setting up our ILIT?

Yes, once you've drafted your ILIT, named your beneficiaries and your Trustee (or Trustees), the next step is to acquire a life insurance policy. You'll go about this process just as you would normally, except that the owner and beneficiary of your policy will be your ILIT. Also, you won't pay the insurance premiums directly. Instead, your Trustee will handle the actual transaction of paying your premiums to the insurance company.

What kind of policy should we use for our ILIT?

You can use an individual life policy---that is, one that insures the life of just one individual. Or, if you and your spouse are both living, you can use a second-to-die (also known as a "survivorship") policy. This kind of policy pays out a death benefit only after both spouses have passed away. Just remember, however, that if you and your spouse are both covered by an insurance policy owned by your ILIT, neither of you can serve as Trustees.

Can we use an existing policy?

Yes. Just remember that if you die within three years of making the transfer, the IRS will include the policy in your estate for estate tax purposes. Also, there are gift-tax considerations if an existing policy is used for an ILIT. Despite these issues, however, you may still find that transferring an existing policy from your estate into an ILIT is well worth it.

How do we make the premium payments each year?

Each year you will transfer enough cash to your ILIT to pay your annual insurance premium. Once you've made the cash transfer, your Trustee will send your payment on to your insurance carrier in time to keep your policy in force. A long as your premium payment follows the "gifting" guidelines, as described below, there will be no gift taxes incurred by either you or your beneficiaries.

What are the rules for "gifting"?

The ILIT works so well because it takes advantage of the tax break allowed for gifts called the annual "gift tax exclusion." As of 2017, each year, you may give away up to $14,000 to an individual completely gift-tax free. You can give $14,000 gifts, as adjusted for inflation to as many people as you like. A married couple can give an individual a combined $28,000 annually, gift-tax free. There is no limit to the total number of gifts the couple may make. You may, of course, give someone more than $14,000 a year. The excess can be applied toward your lifetime estate tax exemption of $5.49 million (the 2017 limit). Remember to always make sure you are following the most current law for your tax year.

What other requirements are necessary to keep the ILIT in force?

Once your ILIT has been set up and your life insurance policy acquired, there's generally very little that needs to be done in the future. Each year (or as long as premiums are due), you'll transfer cash to the ILIT, the Trustee (or your attorney or CPA) will notify your beneficiaries of that fact the Crummey Letter, and then the Trustees will wait the proscribed time to see if the beneficiaries of your ILIT withdraw the money. When they don't, your Trustee will send the premium payment on to your life insurance company. In addition, your ILIT will need a separate tax ID number, and a separate bank account may be necessary. In some cases, you may need to file a gift tax return. Finally, if your ILIT has earned income during the year, it may require a tax return.

Will my life insurance policy be subject to probate?

No, as long as you're beneficiary is not your estate. Once your survivor (or professional advisor) has provided your insurance company with proof of your death, the policy's proceeds are paid out directly to your beneficiaries. This payout generally occurs quickly, privately and usually with no legal expenses involved. Furthermore, the death benefit of your policy passes income tax free to your beneficiaries. Remember, however, that your policy is not completely tax-free. The proceeds from your policy are included in your estate for estate tax purposes.

What if we decide we don't want to keep the ILIT in force any longer?

There's nothing requiring you to continue making insurance payments. Depending on the kind of policy you have, your policy may lapse as soon as you miss your annual premium payment. Or, if your policy has cash value, these funds may be used to pay premiums until all the accumulated cash is exhausted. The one thing you cannot do, however, is transfer a policy owned by an ILIT into your own names. So, if you think that you may need to do so someday, or if you will want to access the policy's cash value for your own purposes, you probably should reconsider the ILIT as a suitable strategy for you.

Questions About Irrevocable Life Insurance Trusts? Talk to an Attorney

Life insurance is one of the best ways to provide for your family and loved ones in the event of your death, and an irrevocable life insurance trust can address various estate planning problems. It's a good idea to speak to an experienced trust attorney who can tell you more about trusts and help you with estate planning.

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