Life insurance is undoubtedly a valuable product, but it must be used correctly for the full benefits to be unlocked.
Without proper estate planning, life insurance can create more problems than it solves, in some instances.
That’s where an irrevocable life insurance trust (ILIT) enters the picture.
Here’s what you need to know about ILITs and when one should consider it for their life insurance needs.
What is an ILIT?
An irrevocable life insurance trust is simple.
It acts as a holding device where ownership of the life insurance policy is removed from your estate and taken over by the trust.
Though you still do have a lot of control over the specifics of the trust at the time of set up, many of the most important aspects are managed for you thereafter.
You’re able to choose the initial beneficiaries of the life insurance policy, define the terms of the benefit, and more.
Remember, an ILIT is, as the name implies, irrevocable.
This means the life insurance policy involved is permanently in control of the trust. You can’t take this same policy back into your own name.
The trust controls the payout of your life insurance benefits upon your death as dictated by the terms you initially agreed upon.
Parties Involved in the Trust
One of the easiest ways to understand how an ILIT works is to see a breakdown of the parties involved in the trust.
- The Insured – The person’s life whom the policy is covering.
- The Creator – The person creating the trust.
- The Trustee – The person who will administer/manage the trust.
- The Beneficiaries – The people/entities who receive the benefits of the life insurance policy when the insured passes.
As you can see, an irrevocable life insurance trust is a multi-pronged and complex system of estate management.
Defining the Benefits of an ILIT
The benefits of an irrevocable life insurance trust cannot be overstated.
There are several important reasons why one would look into an ILIT when taking out a life insurance policy.
A few of the most important include:
- Provide for Family – An ILIT allows you to financially provide for your family upon death, while avoiding estate taxes and dictating the terms of the benefits.
- Provide Liquidity – An ILIT provides liquid cash to deal with your unpaid debts and taxes as well as other final expenses.
- Business Owners – An ILIT allows you to pay your business partner for your share of the business with liquid funds.
- Replace Charitable Donations – An ILIT replaces any charitable donations you’ve made, so your beneficiaries receive their full benefit.
Out of all these benefits, perhaps the two most important come with the first bullet point:
- avoiding estate taxes
- dictating the terms of the benefits
Life insurance policies can sometimes be gouged with estate taxes upon your death. These can greatly diminish the benefit which will be given to your family.
An irrevocable life insurance trust avoids this pitfall.
The money in the trust is held separately from your estate in a legal sense.
The other big benefit is you’re able to dictate the terms of the benefits.
Life insurance policies often leave big payouts to the beneficiaries.
Unfortunately, the nature of these large cash payouts often causes problems. In addition to family disputes, this type of sudden windfall can simply be overwhelming.
An irrevocable life insurance trust enables you to decide who, when, and how your life insurance policy is paid out.
This ensures the benefits are paid as you intended and increases the chance they’ll be properly managed by the recipients.
How Is an ILIT Funded?
As mentioned above, irrevocable life insurance trusts are complex, much more complex than other types of trusts.
Yet at least a basic understanding of them is essential if you’re considering this option for your life insurance policy.
Now that you’re aware of how the actual life insurance payout process works, you must understand how an ILIT is funded since it’s no longer part of your estate.
There are two main ways this is done. You can use crummey withdrawal powers or split-dollar life insurance.
But first you must understand the three-year rule.
The Three-Year Rule
The three-year rule is often implemented by the grantor of the trust.
It states the creator of the trust (the one with the life insurance policy) must live for at least three years after creation.
If the creator does not live for at least three years after creation of the trust, the funds in the trust will actually be included in their taxable estate.
If the creator does live for at least three years after creation of the trust, the funds in the trust will actually be included in their taxable estate.
There is a method around this hiccup.
It’s possible for the grantor to transfer property/cash to the trustee for them to purchase a new life insurance policy on the grantor.
Taking these steps means the three-year rule typically doesn’t apply.
Though this might seem complicated and convoluted, it’s the most popular method and is preferred by most.
Now that you understand the three-year rule, let’s look at the two main ways that an irrevocable life insurance trust is funded.
Crummey Withdrawal Powers
The most common method of funding an ILIT is with crummey withdrawal powers.
Simply put, the trust must have money available for the life insurance payments. Crummey withdrawal power does this by creating an immediate exercisable withdrawal power.
The gift exclusion is used so the beneficiary of the trust receives a gift to withdrawal rights form the trust.
The beneficiary is then directed not to claim the gift.
After one or two months, the gift will lapse. The trustee who is administering the ILIT can then use the funds available as the gift to pay the life insurance premiums for the year.
This ensures the trust remains separate from the insured person’s estate and the life insurance funds can’t be taxed as part of this estate.
Split-Dollar Life Insurance
Another option for funding an ILIT is split-dollar life insurance.
This is a private financial arrangement where the life insurance policy payments are made by the insured person even though the policy is owned by the ILIT.
Even though the insured person is still making the payments as normal, they’re actually refunded these payments by the ILIT.
The ILIT uses an IRS formula to determine exactly how much they need to annually give to the person with the life insurance policy to cover the yearly payments.
There are several ways this can be safely done, both of which include structuring this transfer of money as a loan using crummey withdrawal powers.
Note that split-dollar life insurance arrangements are more complex than crummey withdrawal powers.
A financial advisor will be able to help you understand this type of arrangement more intimately.
Common Mistakes to Avoid Within An ILIT
By their very nature, irrevocable life insurance trusts are complicated and unwieldly things.
Because they can be confusing, the same mistakes are often made. You must avoid these mistakes at all costs to reap the full benefit of your ILIT.
These are the most common ILIT pitfalls:
- Incidents of Ownership – The grantor must not be a trustee or beneficiary of the trust to avoid estate taxes.
- Community Property – If community property is used as funds, it may ruin the tax benefits of an ILIT.
- The Wrong Trustee – Completely trusting the trustee in charge of your ILIT is beyond important. We recommend using a professional fiduciary.
Avoid these common ILIT pitfalls and the process will work much more smoothly.
Types of Life Insurance Available
There are many different types of life insurance policies available to be used as part of an irrevocable life insurance trust.
The same considerations should go into choosing life insurance for an ILIT as it should for any other situation. Most importantly, consider the goals of the trust as well as the needs and preferences of the person buying the policy.
Your two most common options are term life insurance or permanent life insurance.
Term life insurance is a temporary policy which lasts a set term. This is usually for 10, 20, or 30 years. After this period, the coverage is gone.
Permanent life insurance, on the other hand, is permanent. It lasts from the time you buy it until you die.
We recommend selecting a permanent life insurance policy to be used with your irrevocable life insurance trust.
The goal of an ILIT is to ensure funds are available upon your death to cover final expenses and care for your beneficiaries. Permanent life is the best way to meet these goals.
An irrevocable life insurance trust is a good option for many people.
Though they are undoubtedly complex, the basic mechanics behind them are quite simple. And that’s not to mention the many benefits they provide.
Make sure to talk to your financial advisor about establishing an ILIT if it’s in line with your financial goals.