A trust is a common addition to the average estate plan. If you decide to create a trust, the type of trust you create will depend on the goal(s) of the trust. A simple trust can help distribute your estate assets after you are gone; however, there are also several highly specialized trusts that serve very specific purposes. One such trust is an Irrevocable Life Insurance Trust, or ILIT. In this article, I explain why you might want to include an Irrevocable Life Insurance Trust in your estate plan.
A trust is a fiduciary legal arrangement that allows a third party, referred to as a Trustee, to hold assets on behalf of a beneficiary or beneficiaries. The person who creates a trust is referred to as the “Settlor”, “Trustor” or “Grantor.” The Grantor transfers property to a Trustee, appointed by the Grantor. Trusts all fall into one of two categories – testamentary or living trusts. Living trusts can be further divided into revocable and irrevocable living trusts.
What Is an Irrevocable Life Insurance Trust (ILIT)?
An Irrevocable Life Insurance Trust is a specialized trust that provides tax advantages in addition to the general benefits a trust can provide. Specifically, an ILIT is typically used when avoiding estate taxes is the goal.
Life insurance proceeds usually pass to the named beneficiary free of any income tax; however, the payout from a life insurance policy is generally included in the “gross estate” of the policy owner for estate tax purposes at the policy owner’s death. That could make those proceeds subject to federal estate taxes at a tax rate of 40 percent and the State of Maryland estate tax at the rate of 16%. Before factoring in the lifetime exemption, that means that a $5 million life insurance policy would subject the policy holder’s estate to a $2 million federal gift and estate tax bill. Understandably, if you purchase a $5 million life insurance policy you want the entire $5 million to be paid out to the named beneficiary (or beneficiaries). One way to make sure that happens is to create an ILIT.
An ILIT takes advantage of a loophole created by Congress. If an ILIT is created to own the life insurance policy and the proceeds of the life insurance policy are payable to the trustee of the ILIT upon the insured’s death, then the proceeds are not included in the insured’s estate and, therefore, are not taxable for federal estate tax purposes. This applies even though the insured gives the money to the Trustee of the ILIT to pay the annual premiums of the life insurance policy.
Moreover, a properly drafted ILIT also avoids gift tax consequences. Contributions by the Grantor are classified as gifts to the beneficiaries, meaning those contributions would normally also be subject to federal gift and estate taxes. An ILIT, however, avoids gift taxes by requiring the Trustee to notify the beneficiaries of the trust of their right to withdraw a share of the contributions for a 30-day period. This notice is referred to as a “Crummey letter.” The Crummey letter qualifies the transfer for the annual gift tax exclusion by making the gift a present rather than future interest. At the end of the 30-day period, the funds can be used to pay the policy premiums.
Who Should Be the Trustee of My Irrevocable Life Insurance Trust?
Although it is common for the Grantor to also be the Trustee in some types of trusts (such as for incapacity planning purposes), the Grantor should not be the Trustee of an ILIT. If the Grantor is also the Trustee is results in the Grantor having an incident of ownership in the life insurance policy which defeats the purpose of the trust and subjects the proceeds to estate taxes upon the death of the Grantor. Given the complex nature of an Irrevocable Life Insurance Trust, you may wish to appoint a professional Trustee to oversee the trust.
Contact My Experienced Estate Planning Office
For more information, or if you have additional questions or concerns about including an Irrevocable Life Insurance Trust in your estate plan, contact my staff and I by calling 410-654-3850 to schedule an appointment.