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Irrevocable Life Insurance Trusts

Life Insurance is an investment. Like other investments, the value of life insurance is normally included in the total value of an estate when an individual passes away. When the value of an estate exceeds the available estate tax exemption, the excess amount may be subject to a 55% estate tax! Therefore, if an individual has a large life insurance policy, he or she may unwittingly cause a significant tax liability to his or her estate.

In order to avoid having one’s estate pay unnecessary estate taxes, an “Irrevocable Life Insurance Trust”, commonly known as an “ILIT” (pronounced “eyelet”), should be considered. An ILIT is an irrevocable trust, which means that once it established, it cannot be undone (revoked). It must be established for the benefit of someone other than the trustor (the person creating it) or the trustor’s spouse. Most often, the trustor’s children are named as beneficiaries. During the trustor’s lifetime, regular contributions may be made to the ILIT. The contributions will be used to pay for the life insurance policy which is owned by the trust. If structured properly, these contributions will be treated as gifts, but will not be subject to Gift Tax. Upon the trustor’s death, the ILIT will be paid to the named beneficiaries, but will not be subject to any estate tax!

When Might I Need An Irrevocable Life Insurance Trust?

ILIT’s can be used in a variety of ways to maximize tax-free gifting. Let’s look at a hypothetical historical scenario to see how an ILIT works. Robert worked diligently and saved a substantial sum of money by the time he was 50 years old in 2001. At that time the annual estate tax exemption was $1M. Robert created an ILIT in 2001 with a death benefit of $2.5M, payable to Robert’s three children. The annual premiums paid to the maintain the insurance policy were paid by Robert and were considered tax-free annual gifts. In 2006, Robert was unexpectedly killed in a sailboat accident. In 2006, the estate tax exemption was $1.5M and the estate tax rate was 46%. If Robert’s insurance policy had been a part of his estate, and the remainder of his estate was worth $1.5M, his estate would have had to pay $1,115,000 in estate taxes! However, because he used an ILIT, the estate’s tax liability was $0.

How Is An Irrevocable Life Insurance Trust Different From Just Having An Insurance Policy?

While life insurance death benefits are generally excluded from income tax to the beneficiary, they are included as part of the estate of the deceased if the deceased was the owner of the policy at the time of death. If your estate is close to or already over the amount excluded from estate tax, your estate could have to pay a considerable sum in additional estate taxes if you have a large life insurance policy.

Is There A Way To Avoid Paying Estate Tax On Life Insurance Proceeds?

Estate inclusion can be avoided if the owner of the life insurance policy is someone other than the deceased. This assignment must have occurred more than three years prior to the date of death, or the IRS will still consider the deceased as the policy owner for estate tax purposes. The decedent must not have any of what the IRS calls “incidents of ownership”. If you can control the policy – if you can cancel it, surrender it, borrow against it, pledge or assign it, or can change the beneficiary – you are considered the owner of the policy.

If the policy is owned by an irrevocable trust set up at least three years prior to your death, the insurance proceeds will pass free of estate tax. As noted above, the trust is irrevocable. This means that any decisions you make about the policy are extremely difficult if not impossible to change later.

Should I Set Up An Irrevocable Life Insurance Trust?

Many different factors affect the suitability of an irrevocable life insurance trust for your particular estate, including the liquidity of your assets and what other revocable and irrevocable trusts you may have set up. Contact us for a consultation to discuss your estate plan and whether you may want to include an irrevocable life insurance trust as part of that plan.

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