Irrevocable Life Insurance Trust
(ILIT)
One of the main reasons we buy life insurance
is so that when we die, our loved ones will have enough money to pay off our
remaining debts and final expenses. We also purchase life insurance to provide
for our loved ones' future living expenses, at least for a while. That's why it
may seem unfair that life insurance proceeds can be reduced by estate taxes.
That's right--the general rule is that life insurance proceeds are subject to
federal estate tax (and, depending on your state's laws, state estate tax as
well). This means that as much as 40% (currently the highest estate tax rate)
of your life insurance proceeds could be going to Uncle Sam instead of to your
family as you intend. Fortunately, proper planning can help protect your
family's financial security.
The key is ownership
Generally, all the property you own at your
death is subject to federal estate tax. The important point here is that estate
tax is imposed only on property in which you have an ownership interest; so if
you don't own your life insurance, the proceeds will generally avoid this tax.
This begs the question: Who should own your life insurance instead? For many,
the answer is an irrevocable life insurance trust, or ILIT (pronounced
"eye-lit").
What is an ILIT?
An ILIT is a trust primarily set up to hold
one or more life insurance policies. The main purpose of an ILIT is to avoid
federal estate tax. If the trust is drafted and funded properly, your loved
ones should receive all of your life insurance proceeds, undiminished by estate
tax.
How an ILIT works
Because an ILIT is an irrevocable trust, it
is considered a separate entity. If your life insurance policy is held by the
ILIT, you don't own the policy--the trust does.
You name the ILIT as the beneficiary of your
life insurance policy. (Your family will ultimately receive the proceeds
because they will be the named beneficiaries of the ILIT.) This way, there is
no danger that the proceeds will end up in your estate. This could happen, for
example, if the named beneficiary of your policy was an individual who dies,
and then you die before you have a chance to name another beneficiary.
Because you don't own the policy and your
estate will not be the beneficiary of the proceeds, your life insurance will
escape estate taxation.
Caution: Because an ILIT must be irrevocable, once
you sign the trust agreement, you can't change your mind; you can't end the
trust or change its terms.
Creating an ILIT
Your first step is to draft and execute an
ILIT agreement. Because precise drafting is essential, you should hire an
experienced attorney. Although you'll have to pay the attorney's fee, the
potential estate tax savings should more than outweigh this cost.
Naming the trustee
The trustee is the person who is responsible
for administering the trust. You should select the trustee carefully. Neither
you nor your spouse should act as trustee, as this might result in the life
insurance proceeds being drawn back into your estate. Select someone who can
understand the purpose of the trust, and who is willing and able to perform the
trustee's duties. A professional trustee, such as a bank or trust company, may
be a good choice.
Funding an ILIT
An ILIT can
be funded in one of two ways:
1. Transfer an existing policy--You can transfer
your existing policy to the trust, but be forewarned that under federal tax
rules, you'll have to wait three years for the ILIT to be effective. This means
that if you die within three years of the transfer, the proceeds will be
subject to estate tax. Your age and health should be considered when deciding
whether to take this risk.
2. Buy a new policy--To avoid the three-year
rule explained above, you can have the trustee, on behalf of the trust, buy a
new policy on your life. You can't make this purchase yourself; you must
transfer money to the trust and let the trustee pay the initial premium. Then,
as future annual premiums come due, you continue to make transfers to the
trust, and the trustee continues to make the payments to the insurance company
to keep the policy in force.
Gift tax consequences
Because an ILIT is irrevocable, any cash
transfers you make to the trust are considered taxable gifts. However, if the
trust is created and administered appropriately, transfers of $14,000 or less
per trust beneficiary will be free from federal gift tax under the annual gift
tax exclusion.
Additionally, each of us has a gift and
estate tax exemption, so transfers that do not fall under the annual gift tax
exclusion will be free from gift tax to the extent of your available exemption.
The gift and estate tax exemption amount is $5,250,000 (plus any applicable
deceased spousal unused exclusion amount) for 2013. Both the annual exclusion
and the exemption are indexed for inflation and may change in future years.
Crummey withdrawal rights
Generally, a gift must be a present interest
gift in order to qualify for the annual gift tax exclusion. Gifts made to an
irrevocable trust, like an ILIT, are usually considered gifts of future
interests and do not qualify for the exclusion unless they fall within an
exception. One such exception is when the trust beneficiaries are given the
right to demand, for a limited period of time, any amounts transferred to the
trust. This is referred to as Crummey withdrawal rights or powers. To qualify
your cash transfers to the ILIT for the annual gift tax exclusion, you must
give the trust beneficiaries this right.
The trust beneficiaries must also be given
actual written notice of their rights to withdraw whenever you transfer funds
to the ILIT, and they must be given reasonable time to exercise their rights
(30 to 60 days is typical). It's the duty of the trustee to provide notice to
each beneficiary.
Of course, so as not to defeat the purpose of
the trust, the trust beneficiaries should not actually exercise their Crummey
withdrawal rights, but should let their rights lapse.
The key
duties of an ILIT trustee include:
• Opening and maintaining a trust checking
account
• Obtaining a taxpayer identification number
for the trust entity, if necessary
• Applying for and purchasing life insurance
policies
• Accepting funds from the grantor
• Sending Crummey withdrawal notices
• Paying premiums to the insurance company
• Making investment decisions
• Filing tax returns, if necessary
• Claiming insurance proceeds at your death
• Distributing trust assets according to the
terms of the trust
CornerStone Financial
Whether your
nest-egg is worth millions or thousands,
You and your
family deserve it more than the government....
We are here to help you with all of your
financial and insurance needs. Our skilled professionals are licensed with
over 100 top name companies and can help you gain a better understanding of the
concepts behind insurance including investing, retirement and estate
planning. There are literally thousands of products to choose from,
but we can help pinpoint what is best for you and your situation. Please
do not hesitate to contact us if you have questions.
Contact:
Eric Tuttobene
President/CEO
CornerStone
Financial
(615) 427-8780
IMPORTANT DISCLOSURES
The
information presented here is not specific to any individual's personal
circumstances.
To the extent
that this material concerns tax matters, it is not intended or written to be
used, and cannot be used, by a taxpayer for the purpose of avoiding penalties
that may be imposed by law. Each taxpayer should seek independent advice from a
tax professional based on his or her individual circumstances.
These
materials are provided for general information and educational purposes based
upon publicly available information from sources believed to be reliable—we
cannot assure the accuracy or completeness of these materials. The information
in these materials may change at any time and without notice.
