If you are contemplating purchasing a new life insurance policy, be sure to discuss the use of an irrevocable life insurance trust (known as an ILIT) with your advisors before you purchase the policy. An ILIT is an irrevocable trust that you create to hold a life insurance policy on your life. It is typically used to benefit your spouse and your children by holding the policy proceeds in trust after your death.
The main reason people create an ILIT is for estate tax savings. If you die owning the policy, the policy proceeds will be included in your estate and taxed for estate tax purposes. The current federal estate tax exemption is $11,700,000 (adjusted yearly for inflation). If your assets exceed that amount, your estate will be taxed on your death.
Keep in mind that the current $11,700,000 exemption amount is scheduled to drop to $5 million, adjusted for inflation, on December 31, 2025. It may drop sooner to an even lower amount now that the Democrats control the White House and Congress. Even if your estate is not federally taxable, your estate may be subject to state estate taxes. Massachusetts, for example, taxes estates in excess of $1 million. The use of an ILIT could allow your estate to save on state estate taxes resulting in more monies directed to your beneficiaries.
In addition to potential estate tax savings, the use of a trust will allow your trustee to use the policy proceeds for your beneficiaries without giving them full control over the monies. This is important if your children are too young to handle the funds, if you have a second marriage, or if your beneficiaries would not be able to manage the monies successfully on their own.
Here are three things you need to know about ILITs.
Selecting a trustee. It is best to have an independent trustee such as a bank or trust company, or a lawyer or accountant. You can also consider a trusted family member or friend. Your spouse can be a co-trustee, and in some instances can be the sole trustee. However, if your spouse is the sole trustee, the distributions that he or she can make will be restricted to distributions for health, education, maintenance, and support.
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Make sure you understand all the rules. An ILIT requires yearly maintenance and will need to be administered properly. Once the ILIT is signed, you will need to obtain a tax identification number for the trust. The ILIT is a separate entity apart from you so it needs its own taxpayer number. The ILIT will then apply for and purchase the life insurance policy.
Once the policy is in place, you cannot pay the premium directly. You will need to make gifts to the trust, typically using some or all of your annual exclusion amount of $15,000. The trustee will then pay the premiums.
In most instances, the trustee will also need to send yearly notice letters to the trust beneficiaries for tax reasons. The trust may also need to file a gift tax return. If you use a bank or a trust company as your trustee, they will usually handle administration of the trust as part of their services. If not, your lawyer can usually administer the trust for you for a nominal yearly fee.
Existing policies can be transferred with caveats. If you already have a life insurance policy, it’s not too late to create an ILIT and transfer the policy to the ILIT. However, there is a three year “look back” for an existing policy that is transferred into an ILIT. If you die within the three year period from the transfer, the policy proceeds are included in your estate and taxed. If you survive three years, the policy proceeds would not be taxed.
Remember whether you are purchasing a new policy or transferring an existing policy, the ILIT has to be the owner and beneficiary of the policy. This is an important step that cannot be overlooked. People often set up an ILIT and never transfer their life insurance policy to the trust. If you do not change the owner and beneficiary to the ILIT, you will have lost the estate tax savings.