Estate Taxes and your Irrevocable Life Insurance Trust

Today we bring you a very special blog to help you plan your estate and care for your family after your death.  We will introduce the life-changing document, the Irrevocable Life Insurance trust.

The founder of Principal Law, Shivon Patel initially wrote most of this blog as an article last year.  We have changed it. –Mostly in regard to format, and added more research.  We hope this blog article draws a very important issue to your attention.

Your Estate and an Irrevocable Life Insurance Trust

You might think you don’t have much of an estate. However, you have a good life insurance policy.  And you might think that your beneficiaries will get everything you planned and specified with the insurance company.   Think again.  That policy represents money that the law considers to be your “estate.”

Shivon wrote, “Many individuals are not aware that life insurance death benefit proceeds are part of their taxable estate.  And thus, can potentially increase the amount of estate taxes that must be paid.”

Planning Now for the Ones You Love:  Creating an ILIT

That’s right, you might think your loved ones will get the full amount from the insurance company.  But estate taxes can take a big bite.  Shivon Patel, Esquire, adds the poignant details, and we break them down for you:

1. Federal estate taxes are expensive.
2. And they must be paid in cash,
3. Usually, they must be paid within nine months after the date of your death.
4. Very few estates have this kind of cash.  So, estate assets often have to be liquidated.
5. However, rest assured, the law has an answer.  “If you plan ahead, estate taxes can be substantially reduced or even eliminated.”

Planning Ahead with an Irrevocable Life Insurance Trust

When you have well-established life insurance, it’s also time for you to learn about the “ILIT.”  This is an irrevocable life insurance trust.  This document “allows you to reduce your estate taxes so more of your assets can go to your loved ones.”

Let’s look at a Mini-case Study: Mr. Billet and the ILIT

Mr. Bradley Billet, age 55, has a young wife of 41.  He also has two teen-aged daughters.  He is in excellent health, a non-smoker and an active person.  But he knows the statistics about male vs. female death risks.

He wants to leave them with enough money to care for themselves.  At least for a little while.  Just in case, as he says, “He gets hit by a bus.”

Shivon could have been writing about our Mr. Billet.  She wrote, “For example.  Suppose a father owns a $500,000.00 life insurance policy and subsequently passes away.  His wife and two children are beneficiaries under the policy.”

Looking at the Legal Heart of the ILIT Matter

Here’s the heart of the matter:  “The $500,000.00 death benefit is not taxable to his wife and children as income.  But it is generally taxable as part of his gross estate.”

This tax debt could make it very difficult for the widow and children.  The available income could very limited after his death.  “Such taxation may reduce the amount available cash to support his children and wife after his death.”

Estate Planning:  How the Irrevocable Life Insurance Trust Works

The ILIT is useful in this situation.  It allows the death benefit to avoid estate taxation by removing the father’s “incidents of ownership” over the life insurance policy.

To be specific, here’s how it works.  “The ILIT owns your life insurance policy for you, and is the life insurance beneficiary for the death benefit proceeds.  Thus, since you do not own the life insurance policy, the death benefit proceeds will not be included in your estate.”  Therefore it cannot be subject to estate tax.

1. At your behest, “The Trustee makes the premium payments.”
2. And he “must follow the instructions you put in your irrevocable life insurance trust document, therefore providing you utmost control over your policy and death benefit proceeds.”

A working definition of this amazing legal document can be researched at Investopedia.  Here, you can discover the basics. “The irrevocable life insurance trust (ILIT) is a trust that cannot be rescinded, amended or modified in any way after its creation.

Once the grantor contributes property or life insurance death benefits to the trust, he or she cannot change the terms of the trust or reclaim any property left to the trust.  

We learn that there are actually 3 good reasons to establish an ILIT.

1:  Create the ILIT to protect beneficiaries from losses due to estate tax considerations.
2:  It is wise to use an ILIT if you are leaving a “large sum of money unsupervised to a minor or an irresponsible adult.”
3:  The last and most general reason for utilizing an ILIT is for asset protection.

Estate Tax Pitfalls and Improper Planning

Shivon gave readers an important warning for estate planning.  “Those individuals interested in utilizing these trusts should be aware of the potential tax pitfalls associated with improper planning.”

1. She explained, “One major pitfall relates to an IRS rule that taxes life insurance death benefits to the estate if the owner of the policy dies within 3 years of transferring the insurance policy to the ILIT.  Therefore, it is preferable, if possible, for an individual to first establish an ILIT.  And then allow the ILIT to purchase the life insurance policy.”
2. Likewise, there is a second major pitfall, and Shivon alerts us to it this way.  “Another area of concern is associated with gift taxation.  If you transfer an existing policy that has a cash value to an ILIT, gift taxes may be due.  The ILIT is considered a separate entity and thus, any funds contributed to such a trust will be considered gifts subject to gift taxes.  This also includes amounts contributed to pay the insurance premiums.  A properly drafted ILIT, however, will normally include language that alleviates some of the negative effects of gift taxation by efficiently utilizing the annual exclusions available.”

The Delicate Art of Crafting an Irrevocable Life Insurance Trust

A trusted online financial planning research source, explains how this works for your estate.  “Your trustee can simply send your trust’s beneficiaries something called a “Crummey” letter each time you transfer money to the trust.  This letter would advise them that they can ask for their share of that money within a specific period of time.”  You see, as long as they can immediately withdraw the money any time, the gift tax won’t apply!  Needless to say, there is a certain amount of trust in the beneficiaries with this arrangement.

“Of course, the amount you’re giving the trust is negligible compared to the eventual proceeds of your policy.  And particularly if it’s divided among several beneficiaries.  If they take the money now, the premiums will go unpaid and the policy would lapse.  This is usually sufficient encouragement for the beneficiaries to leave the money with the trust so it can pay for the policy.

Shivon wraps up the ILIT by summarizing.  They “are used extensively in estate planning because they remove assets from an individual’s estate, thus reducing estate taxes.”

She reminds her readers and clients.  “An ILIT should be drafted by an estate planning attorney to ensure compliance with state and federal laws.  And proper tax planning should be done in advance.”

“Properly designed and implemented” by a qualified estate planning attorney, “ILITs allow a surprisingly high degree of flexibility coupled with significant estate planning benefits.

Terrific Take-Aways from Today’s Blog on Irrevocable Life Insurance Trusts

When doing estate planning of any kind, be sure you have secured the help of an attorney.  The attorney must have the qualifications and the experience.  He must be able to help you through the intricacies of the national, state and local regulations.

At Principal Law, Estate planning is one of our most prized specialties.  Family is important to her.  So, she understands how you feel about leaving a secure future for yours.  Shivon Patel is devoted to helping you plan the best possible futures for your loved ones.

And we close with the words of Suze Orman.  “Estate planning is an important and everlasting gift you can give your family.  And setting up a smooth inheritance isn’t as hard as you might think.”