After reading our first blog on life insurance, you may be wondering about some of the more complex types of life insurance and estate planning. In today’s blog, we will be getting into Irrevocable Life Insurance Trusts or ILITs. This is an incredibly powerful tool for estate planning to those in the upper echelons of personal wealth.
What is an Irrevocable Life Insurance Trust?
Basically, an Irrevocable Life Insurance Trust is a combination of a life insurance policy within an irrevocable trust. The type of life insurance is almost always a permanent policy. However, a convertible term policy is a viable option as well. The most notable aspect to this is that an insurance policy has no on-going taxation (tax-deferral). If structured correctly, it pays out tax-free benefits. The tax-deferral piece is essential because trust tax brackets are very compressed. The highest federal rate of 37% kicks in at an income of only $12,950!
That being said, the irrevocable trust part means that it is a separate entity from the person who puts the money into the trust (called the grantor). The irrevocable trust has its own tax ID number and is treated as its own entity in the eyes of the IRS. As such, this shields the money in the trust from a possible lawsuit against the grantor. The drawback is it is a one-way street. Once the grantor puts the money into the irrevocable trust, they no longer have a claim on it. That is what the irrevocable part means – no takesie backsies!
After you put money into the ILIT, your chosen trustee will act in accordance with the provisions of the trust. Unfortunately, that chosen trustee can’t be you, so you’ll have to consider who that person will be.
Why Would Someone Want an ILIT?
The primary use of the Irrevocable Life Insurance Trust is to put assets outside of the estate. You do this for the sake of estate tax and generation-skipping transfer tax (GSTT) purposes. Back before 2010, the ILIT used to be more popular when the estate tax exemption amounts were much lower. The ILIT was a way to get around paying estate tax on a larger sum down the road. You would do this by depositing it into the ILIT, deferring taxation while the money grows and then having a tax-free death benefit OUTSIDE of the estate. For reference, the current estate tax rate on taxable estates above $1 Million is 40%. The GSTT would then be another 40% on top of that. Therefore, the ILIT is a HUGE tax savings opportunity.
With that in mind, the current federal estate tax exemption is at $11.58 million in 2020 (double that for a married couple). Consider yourself extremely lucky if you are looking to use an ILIT for estate tax planning. Just be sure to check state estate tax rates since they vary. However, the federal exemption is scheduled to reverse back down to ½ of the current amount in 2026. This could possibly happen sooner depending on political outcomes as well. If you have assets in the $10+ million range, it could be a great time to shift a portion of your wealth outside of your estate –especially with the potential tax law jockeying later this year depending on election results.
Likewise, you may find an ILIT useful because it sets money aside for heirs or causes separate from personal assets. This can be important if you’re in professions with a high likelihood of a lawsuit or in order to set aside money from a windfall to protect it from future risks. There is a level of certainty that the heirs or causes will get the money promised to them, as long as the insurance policy is well funded.
Finally, the grantor specifying the operations of the trust then retains control over the assets to a degree. Sometimes this is referred to as “control from the grave.” Simply, the money can have stipulations attached to it such as: no distributions prior to a beneficiary’s age X, annual distribution amounts and so on. This might be advantageous in planning for a beneficiary with a disability. It could also be good if you’re looking to reduce the likelihood of a beneficiary’s poor life choices wiping out the accumulated wealth.
Sounds Good To Me – How Do I Get One?
An ILIT needs an attorney to set up the trust correctly, including beneficiaries, and a life insurance agent who can find the right policy.
It is important to work with a qualified attorney. You only have one chance to create the trust correctly-–revisions down the road can be difficult if not impossible to make.
Aside from the main trust document, there is another important piece of legal paperwork called the Crummey Letter. The Crummey Letter allows the beneficiary to withdraw funds from the ILIT for 30 days. This allows the contributions toward the Irrevocable Life Insurance Trust to qualify for the annual gift-tax exemption ($15,000 per grantor, per beneficiary in 2020). This is another important tax-minimization technique.
The life insurance policy is typically a cash-value policy such as universal life which is most common. In most cases, policy design tries to maximize death benefit while making sure the death benefit is guaranteed for the grantor’s life. Second-to-die policies are also common (two insureds, payout at death of second). Therefore, it’s critical to work with someone who is qualified to get the best possible policy for your situation.
You know that feeling of “I wish I hadn’t done that.” That can be a real thing with an ILIT if you go into it without full awareness of the possible pitfalls. We want to make sure you don’t feel that way, so here’s what you need to know:
- They can’t be undone. Hence the word “irrevocable.” You will completely lose access to the money when you put it into the trust. If you think you might need it sometime later, an ILIT is not for you.
- There’s no flexibility. Pick your insurance person, attorney, trustee and beneficiaries carefully. Again, once it is done, it’s done, and it’s hard (or very expensive) to change after-the-fact. Do the work up-front so you don’t have regret later. With an ILIT, the details really matter.
- The complexity & cost. In some cases, an ILIT is not the best way to get around estate taxation or to protect assets. Make sure you look into other possible methods. Sometimes, there are ways to make it simpler, more flexible or cheaper to get to your desired destination. A qualified financial advisor can help you explore your options.
After reading this, hopefully you have a better understanding of what an ILIT is and what it can do for you. Likely, you have more questions than answers regarding your personal situation and how an ILIT might fit in. Fear not – we offer free one-hour consultations to dive deeper into your needs and explore the right solutions for you. Contact us today!
The next installment will feature using a life insurance policy for additional retirement income, so stay tuned!