An Irrevocable Life Insurance Trust, or ILIT, should be of interest to any person buying life insurance. The ILIT is not just for people with estate tax issues. The ILIT can allow you to control how and when insurance proceeds are distributed to beneficiaries. Rather than going straight to the beneficiary, the insurance company pays the proceeds into a trust that then pays the amounts to the beneficiary as quickly or as slowly as you decide. Such a trust can be particularly beneficial when the potential beneficiary is either younger or may have potential marital issues or difficultly managing money.
The ILIT’s most popular feature is its ability to assist a person or family with estate tax issues. In addition to the federal estate tax, Maryland residents need to plan for the Maryland estate tax and Maryland inheritance tax, neither of which have the current large exclusion of the federal estate tax. The federal estate tax, while ever changing, will likely never go away and no one can reasonably assume you will not be subject to it in the future. Nonetheless, the ILIT should remain a simple and effective estate tax planning tool regardless what the future changes may be. While life insurance proceeds may not be subject to income tax, the estate tax may apply to life insurance policies owned at the time of death. Proper planning through use of an ILIT can eliminate an insurance policy from the person’s taxable estate. While professionals, such as a good insurance agent, will know when a client should see an attorney to form an ILIT, it is worthwhile to have a basic understanding of the ILIT and how it works.
The IRS considers all property owned by a person at their death to be part of their taxable estate. Many do not realize their life insurance policy is an asset that’s part of their taxable estate, and, considering the real value of the death benefit is to anyone but the decedent, that view is understandable. However, federal tax law considers any policy “controlled” by the insured to have owned it at their death. If controlled, then the IRS will include the policy’s death benefit as part of the person’s estate. Therefore, if the IRS taxes the policy’s death benefit at an estate tax rate of 45%, the beneficiary of a $500,000 policy will only receive $225,000.
Additionally, an ILIT may also benefit a person with potential state tax issues. While the amount exempt from federal estate taxes has increased over time, your state’s estate tax rate may have remained the same. For instance, if your insurance policy causes your estate to be in excess of Maryland’s estate tax exemption, then the excess caused by the inclusion of the unprotected life insurance policy could be facing the 16% tax rate of the Maryland estate tax. If the person had established an ILIT, then there would have been no taxes due.
Implementing the Plan
When a person has potential estate tax issues, attorneys generally suggest that the person form an Irrevocable Life Insurance Trust. After the attorney drafts the trust documents, either a new insurance policy or an existing policy will be placed into the trust. If possible, the person would rather it if the trust purchases a new insurance policy. While transferring an existing policy may be the only option, the person must survive for three years before the policy will not be included in their estate and there could be gift tax issues if the transferred policy already has substantial value. The attorney will usually work with an insurance agent to choose the appropriate policy.
The person will need to fund the trust so it can purchase or make payments on the policy. To eliminate gift tax consequences, the person may prefer to transfer only amounts less than the annual gift tax exemption amount, which at this time is $14,000 per recipient. Since the trust can have multiple beneficiaries, the person may be able to give multiple gifts of the annual amount in order to fund the trust.
To qualify as an ILIT, the trust must be irrevocable and the founder cannot be the trustee. Therefore, the owner will not be able to reclaim the amounts contributed or the policy, and the owner will not be able to change the beneficiary of the policy or the beneficiaries of the trust. Further, the ILIT’s founder will not be able to borrow against the value of the policy.
In addition its ability to reduce estate taxes, the ILIT can provide other benefits as well. The ILIT’s life insurance policy will generally distribute its proceeds to the trust. The trust can then freely distribute the proceeds to the trust’s beneficiaries in accordance with the trust documents. The ILIT can, therefore, be used to quickly get cash to the person’s family if needed. Further, the trust can be drafted to delay the distribution. For instance, the trust can withhold payment until when a child attends college, reaches a designated age, completes a foreseeable bankruptcy or divorce, or any other concern you may have about a beneficiary has been resolved. In contrast, an insurance company will immediately distribute life insurance proceeds, even if not in the best interests of the beneficiary.
Further, families with estate tax issues can direct that the trust use the funds to purchase assets from the estate. This will provide liquidity to the estate and can may simplify the distribution of the assets of an otherwise illiquid estate. Since illiquid estates with estate tax issues will need cash to pay the estate taxes, the ILIT can both pay the estate taxes due while excluding its own assets from the estate.
While the ILIT has its burdens, the simplicity of the ILIT, the tax benefits, and its ability to transfer assets in the person’s chosen manner, will continue to make the ILIT a popular tool for estate planning.
For additional information or to protect your life insurance through an ILIT, please contact Jeff Rogyom at (410) 929-4578.
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