Is an Irrevocable Life Insurance Trust Right for You?
September 6, 2016 | Your Finances
If you’re concerned about your family paying estate taxes when you die, setting up an irrevocable life insurance trust (or ILIT) may be a smart move. An ILIT can help provide liquidity to pay estate tax, preserving your assets for your family. In 2016, the estate tax impacts estates that are valued over $5.45 million, according to the IRS.1 So in the case of a married couple, with proper planning, that couple will not pay estate tax unless their estate’s combined value is more than $10.9 million.
When you pass, everything you own is included in your estate, including life insurance death benefit proceeds. If these death proceeds are a considerable amount, this can set your beneficiaries up for paying estate tax and ultimately reducing the legacy you worked so hard to pass on.
An irrevocable trust can be designed to receive, hold and manage a wide variety of assets. An ILIT works as a holding vehicle for life insurance—when you set up an irrevocable life insurance policy, the trust owns this policy, removing the policy death proceeds from your estate when you pass away.
“Despite the irrevocable nature of this trust, an irrevocable life insurance trust can be a flexible vehicle that families who are concerned about paying estate tax can use to safeguard the trust assets through a number of generations,” says John Muth, director of advanced planning at Northwestern Mutual. “This trust allows you to lay out a road map to hold, preserve and manage wealth for your beneficiaries.” The trust is irrevocable in the sense that once you set it up, you can’t revoke it or modify the provisions of the trust. Muth adds that ILITs can remove assets from your estate, making the trust-held assets immune from estate taxes and free of probate, which makes them valuable tools in an estate plan. However, passing wealth through multiple generations can create unique tax issues, so be sure to consult your tax attorney.
When you set up an ILIT, you commit to making regular payments to the trust to pay the life insurance premiums for the policy held in trust. Initially purchasing a permanent life insurance policy is a common way to fund an ILIT, but term life insurance is also an option.
“You can also fund an ILIT with a term insurance policy and then later convert that policy to a whole life policy,” says Muth. “That way, you can set up the trust when you are younger, preserving your insurability and avoiding higher premiums with a term life insurance contract, and then convert to a whole life policy later.”
The cash value of the life insurance can be accessed by the trustee for ILIT distributions if needed before the insured’s death. Once you pass on, the proceeds can be invested and used to benefit the ILIT trust beneficiaries. The typical ILIT beneficiaries are anyone you designate in your trust document, such as a spouse, children, grandchildren, great-grandchildren and other future generations as well as charities.
When you set up the trust, you are in the driver’s seat in terms of how the trust directs the proceeds will be distributed in the future. This is because as the trust grantor, you can establish specific standards and rules as to how your trustee should invest the proceeds and ultimately distribute this wealth to your trust beneficiaries.
While trusts such as these are set up to help minimize estate and inheritance taxes, complete avoidance of such taxes isn’t always possible.
Here are some important considerations to think about as you consider whether an irrevocable life insurance trusts is right for you.
1. Clearly define your wishes. Creating a trust isn’t a slam-dunk. When you create an irrevocable trust, you must make a series of very deliberate decisions about how the trust assets will be distributed after your death. Many people who might be subject to the estate tax procrastinate on these types of tasks because they are busy running businesses, raising children and/or dislike contemplating their own mortality.
“It is easy to put these tasks off,” Muth says. “Often that happens because individuals don’t want to be locked into one particular asset distribution picture based on today’s environment.” Fortunately, strategies exist to adjust to changing circumstances. The attorney who drafts the trust document can provide flexibility in how the trust is administered and can help deal with future circumstances that might not be apparent when the trust is created. In addition, the life insurance policies and other assets in an ILIT may be able to be moved to a subsequent ILIT, one that has new provisions that meet the client’s updated needs. “A subsequent trust is a new trust with similar wishes or goals. For example, let’s say you create a trust and then get divorced; you may be able to transfer assets to the new trust that excludes your ex-spouse from the provisions.” The initial trust, if holding minimal assets, can then be dissolved by the trustee if trust termination is a reasonable action based on the current situation. Creating the option of a subsequent trust would cost some money to set up, so talk to your estate planner about costs when you are building in flexibility.
2. Increase liquidity. By using an insurance policy to fund an irrevocable life insurance trust, you don’t have to put stocks, other investments or property that you want to actively control in the trust. That means you maintain control over your other investment assets while the ILIT builds its own cash value that can be available to the trustee to provide income distributions to trust beneficiaries if the need arises before the policy matures to its full value.
In addition, the death proceeds from the ILIT life insurance can be used to provide liquidity for any estate or inheritance taxes that might be due. Further, these proceeds can replace wealth that the grantor spent during his or her lifetime on retirement income or long-term care and medical costs. Accordingly, this framework will benefit your heirs because they won’t be then forced to sell your house or highly appreciated stock, take distributions from qualified plan or IRA assets or try to sell illiquid assets to pay estate or inheritance taxes.
3. Trustees. A trustee is someone you name who will manage the ILIT and, among other things, decide when income or principal distributions are made to trust beneficiaries, subject to the terms of the trust. While choosing a trustee for some might be easy, actually finding one for the long term can be challenging. Trustees must have the willingness and ability to carry out the terms of the trust. As the trust ages, trustees may die or become incapacitated, creating a need for successor trustees.
Fortunately, you can set up a trust with successor trustees in the event that problems crop up with your first choices, Muth notes. You can also set up a clause in the trust document so that beneficiaries can vote to select new trustees by a majority vote if the planned successor trustees are unavailable.
Even if your estate is on the edge of requiring an estate tax payment, an ILIT should still be a consideration. “If your estate is on the bubble of paying the estate tax or you believe that you will be significantly above that threshold in the future, an irrevocable life insurance trust is a good option to at least think about,” says Muth. Being on the bubble of paying the estate tax would include individuals with an estate that will be near or at $5.45 million (or couples near or at $11 million). In addition to the estate tax, some states charge a separate inheritance tax. Irrevocable life insurance trusts can help provide liquidity for those state death taxes as well.
An irrevocable life insurance trust offers many benefits that can preserve the assets you’ve worked so hard to accumulate for the benefit of your family and future generations. Although there is a lot to consider, ILITs support estate planning by getting the right property to the right people at the right time. Be sure to consult with an experienced estate planning attorney to evaluate if an irrevocable life insurance trust is right for you. Also, consult with your financial professional to see how an ILIT might fit into your overall financial plan.
1Internal Revenue Service, What’s New: Estate and Gift Tax, March 30, 2016, https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax