Most people put “buy more life insurance” on the very bottom of the things that excite me list. But if you’ve realized that life insurance is often the most cost effective answer to several very important problems, you have probably also heard talk of an irrevocable life insurance trust.
What is an ILIT? And why would you need one?
Life insurance proceeds are not taxable as income, but if you’re not careful about ownership of the policy, the proceeds are subject to the estate tax, which means 40 cents out of every dollar might be lost. The key to keeping life insurance proceeds safe from the estate tax is pretty simple – you should not own the policies on your own life. If you’re the owner of a policy and the insured person under the policy, the proceeds will be part of your taxable estate. An ILIT (pronounced EYE-let) are viewed to some as a time-tested and IRS approved way to split these factors up – and protect the proceeds from the estate tax.
Here’s the basic idea.
Suppose I plan to buy $1 million in life insurance on myself to make sure my kids have money for college if I die while they’re young. If I buy the policy myself, then the proceeds are at risk because I’ll own a policy that insures my life. The $1 million in proceeds will be part of my taxable estate, and if the value of all of my assets exceeds my exclusion amount (currently $5,430,000), then the life insurance proceeds will be subject to the estate tax.
Instead of buying the policy myself, I can create an irrevocable trust that will buy the policy. When the proceeds get paid out, the insurance proceeds won’t be part of my estate because I made sure that I wasn’t the owner and the insured. When I die, the proceeds will be paid into the trust, which will include my instructions to make sure my kids graduate from college.
There are a few features of an ILIT to be very careful about.
First, I will designate someone to manage the trust (called the trustee). I cannot be the trustee. If I am, the tax laws will treat the proceeds as mine despite the trust. My spouse should not be the trustee because the IRS looks at spouses as one unit; and if my spouse owns the policy as trustee, it’s the same as if I own the policy. My kids are too young to be the trustee, and even if they were old enough to have that job, the rules say that I effectively control the policy because my kids are very likely to follow my instructions. This means that I need to name someone more independent to be the trustee of my ILIT. Siblings, close friends and my trusted advisors are the best bet.
Second, if I pay the premium on the policy from my own funds, the laws treat the proceeds as mine despite the trust. The most common solution is to make gifts to the trust and let the trustee use the funds to pay the premium. We’ve already seen that the rules ignore my ILIT if I have too much control over the trust. If the trustee is required to pay the premiums using money I give for that purpose, doesn’t that also seem suspicious? It does! To make this work, I need to give the money to the trustee, and then the beneficiaries of the trust (my kids) need a chance to take the money out. If they leave the money in the trust, then the trustee can pay the premiums without any risk. This withdrawal right is crucial.
So why doesn’t everyone have an ILIT?
In many circumstances, the person buying the policy names his or her spouse as the primary beneficiary of the insurance. Continuing my example, if I buy $1 million in coverage to provide for my kids, it’s pretty likely that I’ll tell the insurance company to pay the proceeds to my spouse, who will in turn take care of my kids. Any asset that I leave to my spouse is protected from the estate tax by the marital deduction. So why even consider an ILIT? Remember that in estate planning, you’re always playing the What If game. What if my spouse dies before me? Who will the insurance company pay? What if my spouse remarries and gives all the money to the charming pool boy or curvy personal trainer? When you’re playing the What If game, a trust should always be considered because it could deal with all sorts of possibilities.
Another common way to address these issues is cross-owning policies. Husband owns the policy on wife’s life, and wife owns the one on husband’s life. This avoids the fundamental issue (having the insured own the policy on his or her life). But it doesn’t address the What Ifs.
Finally, an ILIT requires annual attention. Records must be kept to document the withdrawal rights, and actions by the trustee should be reduced to writings and kept for the term of the trust. If the premium exceeds $14,000 a year, then gifting money to the ILIT might mean that an attorney or an accountant needs to file a gift tax return every year.
ILITs can be tricky to design and cumbersome to administer. If you’re buying a term insurance policy, you should weigh the burdens of having an ILIT against the likelihood that the policy will still be in place at your death. Permanent insurance policies aimed at paying estate tax probably should be held in an ILIT. But an ILIT may not make sense for policies meant to address lifetime goals (such as paying off a mortgage or paying for college).
All insurance analysis and insight provided represents a courtesy extended to you for educational purpose and you should not rely on this information as the primary basis of your insurance planning decisions. We are not licensed insurance professionals. You should consult qualified licensed insurance professionals regarding your specific situation.