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Irrevocable Life Insurance Trusts
Today it is not uncommon to see an estate plan that is comprised of a Will, a Revocable Living Trust, and an Irrevocable Life Insurance Trust. Irrevocable Life Insurance Trusts can also be a valuable estate planning tool. Irrevocable Life Insurance Trusts or ILITs are commonly used in estate planning. As the name implies ILITs are vehicles for holding life insurance policies, but they can also hold other types of assets such as cash or annuities. The goal of this type of Trust is to shift the ownership of life insurance policies away from the insured, and place them in a vehicle which avoids or reduces the estate tax and penalty periods associated with benefits available through governmental programs like Medicaid (Title 19).
Irrevocable Life Insurance Trusts are commonly used as an asset protection technique. After a specific period of time has passed, these assets are not considered a part of your estate. When you die, the Trustee receives the death benefit from the life insurance policy. These proceeds can then be distributed to your family, held in Trust, or used to purchase assets from your estate or from your Revocable Living Trust. If the money used to buy the insurance was in your estate, it would be part of your estate for tax purposes, and would pass through probate. Because those funds have been used to purchase life insurance inside of the Trust they will pass tax free to the beneficiary. Funds will pass probate free and are not subject to the market risk of other investments.
If your estate has insufficient liquid assets to pay estate taxes, ILITs can be used to plan for this problem. The federal estate tax is due in a relatively short time after the date of death (9 months). The amounts can be staggering. Folks with large estates often do not have that much cash or assets that could readily be converted to cash in nine months. The need to pay estate taxes has caused many a farm, family business, or major real estate holding to be sold at a “fire sale” price to pay the estate tax. Life insurance can provide the money needed to pay the estate tax. By having the policy purchased by and held in an ILIT, the proceeds can be used to provide the needed liquidity for your estate, and yet not exacerbate the estate tax problem by being included in your taxable estate.
An ILIT is a legal entity separate from the person who creates it (the Grantor). The ILIT is created by signing a Trust agreement where the Grantor irrevocably transfers property (commonly cash or an existing life insurance policy) to a third person called the Trustee (commonly the Grantor’s children or other relative) who holds that property in Trust for the benefit of the people who are named as beneficiaries. The Trust will either hold the transferred insurance policy, or if cash is transferred to the Trust, use the cash to purchase a policy on the life of the Grantor. In either case, the life insurance policy will name the Trust as the beneficiary, which will collect the insurance proceeds at the death of the Grantor. This can also be funded with policies insuring the lives of both spouses, where the payout occurs at the second death, commonly called second-to-die policies.
If funds are transferred to the Trust and the Trust buys a new life insurance policy, the proceeds from the policy will be sheltered from estate taxation. On the other hand, if the Grantor owns existing policies and transfers them to the ILIT, the Grantor must survive for three years after placing the policies in the ILIT in order to avoid estate taxation on the death benefit. For this reason, it is best to have the Trust buy new policies whenever it is possible to do so.
Most people already own life insurance policies. If existing policies are contributed to your ILIT, the death proceeds will be drawn back into your taxable estate if you die within three years of the gift. For this reason, it is sometimes advisable to obtain a new policy, if you are insurable. If you are thinking about going this route, under no circumstances should you cancel your existing policy BEFORE you apply and are accepted for a new one. You do not want to run into the situation where you cancel your present policy and get denied for a new policy. If you do not qualify for a new policy, you will want to transfer your existing policy into the ILIT.
If an existing policy is transferred to the Trust, the cash value of the policy on the date of transfer constitutes a gift. This can create a problem. There are usually ways to work around this, but you should speak to your advisors about it prior to any transfer being made.
By utilizing an ILIT in your estate planning, all proceeds of life insurance policies can pass to your spouse, children or other named beneficiaries, free of estate tax, income tax, as well as probate fees. The proceeds from all life insurance policies would also be protected from creditors.
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