Benefits of Irrevocable Life Insurance Trust for Estate Planning
Trusts are an effective estate planning tool for accumulating wealth and protecting assets for your loved ones without risking the loss of your assets to creditors should you become incapacitated or die. Trusts can offer significant tax benefits, including the ability to gift assets more than once while retaining their value in the trust. Our experts can advise you on the best type of irrevocable life insurance trust suited to your needs.
Almost every adult you know has some form of life insurance coverage – either through their workplace or privately owned. An irrevocable life insurance trust is a special type of trust that can be used for estate planning purposes. An irrevocable life insurance trust (ILIT) is a way for you to manage the assets of your life insurance policy outside of probate. The irony is that most people who have life insurance policies covering their lives have the impression – right or wrong – that the money to be paid out from those policies is tax-free.
The Tax Results of Life Insurance
What many fail to comprehend fully is that the death benefits of life insurance policies, when paid out, are income-tax-free to the beneficiaries- but that the amount of the total death benefit is normally included in the calculation of the IRS Taxable Estate. When the beneficiaries receive the funds directly from the insurance company, no income tax is deducted, and the full amount is paid out as expected. However, the executor of the deceased’s estate will be sending in two specific federal tax returns. One of course will be the final federal income tax return, but the other holds more importance for our discussion here.
That second federal tax return is the Gift and Estate Tax Return and will consider the total value of all the assets of the estate everything from tools in the garage, to paintings on the wall to coin collections and the financial accounts of every kind (no matter where located) plus any real estate, any retirement assets and any life insurance that is owned in the ‘Wrong’ manner.
Given the large amount of money that is paid out every year in life insurance policy death benefits, it’s surprising in one respect that this problem is not better well-known. Today, the actual pure cost of death benefits is lower than it has ever been – and the size of the term insurance policies being established by many people is amazing. Indeed, life insurance not only covers the debts and obligations of the insured but it’s also being used as a way to create wealth for the next generation. Some of the wealthiest and most widely known families in America have made significant use of Life Insurance Trusts. It goes like this:
- Grandfather creates Life Insurance Trust and funds it with a policy for $1 million on the lives of both Grandparents.
- Dad and/or Mom (the adult children of Grandfather) establish a separate Life Insurance Trust in favor of their children. Since Dad and/or Mom are younger and healthier than Grandparents, more life insurance death benefits can be acquired at a lower cost. They choose to each have separate policies for $2 Million each owned by separate Life Insurance Trusts.
- Adult child (maybe mid-40) establishes two separate policies – each owned by two separate Life Insurance Trusts. One is for $3 Million, owned by the trust established with his spouse as the beneficiary. The other policy is for $ 3 million, owned by another Life Insurance Trust with that policy being on both the Adult Child and Spouse.
- The Life Insurance Trust is being addressed here specifically for two reasons:
- To address the tax issue as it pertains to protecting the total value of the estate; and
- To address the way in which Life Insurance Trusts can be used for lawsuit protection and divorce protection.
Estate Tax Applications
There are two Estate Tax applications for life insurance.
First, where the total value of the estate is large enough to trigger an Estate Tax, a policy of policies held inside of an irrevocable Life Insurance Trust outside the Estate can pay off to the trust and be used by the survivors of the deceased to pay any taxes on the Taxable Estate that may be due.
Second, where the Taxable Estate includes life insurance, the policy of policies can be removed from the Estate and ownership transferred to a Life Insurance Trust outside the Estate. There are guidelines (i.e. ‘the 3-year rule’) to follow. However, with some thoughtful planning and good counsel, you can move the policies outside your Estate and have them held such that the payoff is both income-tax-free and estate-tax-free.
Asset Protection Features
When funded with cash value Life Insurance policies or other assets such as mutual funds, cash, certificates of deposit, etc. the assets inside of the irrevocable Life Insurance Trust are beyond the reach of our creditors and depending on who the beneficiaries are, beyond the reach of a divorce court. The irrevocable gifts you make into the policy take them out of your estate so that in the event of a divorce or lawsuit, they are not ‘yours’ for the taking.
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