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Home / Advanced Estate Planning / What is an ILIT (Irrevocable Life Insurance Trust) and why would you want one?

What is an ILIT (Irrevocable Life Insurance Trust) and why would you want one?

September 21, 2012 by Sinclair Prosser Gasior

If you own life insurance, congratulations!  Sadly, most of us put off this critical element in our family’s financial planning, which may have devastating consequences on the loved one left behind.

You probably know why life insurance is so important.  Young families need it to replace part of the breadwinner’s income.  Mature Americans find it provides their heirs with a source of funds to pay estate taxes.  Investors have discovered that innovative insurance products help them build cash value, tax deferred, for long-term goals like retirement.

But remember, buying life insurance may be only part of the solution.  Without proper planning, it can actually add to your estate tax bill.

Countless well-meaning parents, spouses and others make a simple but costly mistake when buying life insurance policies.  They don’t think about who should own the policy.

Unfortunately, that simple act could cost your heirs plenty.  Here’s why.

Every American is entitled to an estate tax exclusion on the first part of his or her estate.   With proper planning a married couple can double that exclusion shelter.   The Federal exclusion is $5 million in 2012.  The Maryland exclusion is $1 million.  You need to take every precaution possible to reduce the value of your estate for estate tax purposes, and that includes life insurance planning.

While your beneficiaries will receive the death benefit income tax-free, the proceeds are not income tax-free.  Say, for example, that your home, retirement benefits, and other assets total $1 million.  But add in a life insurance policy with a death benefit of $1,000,000.  Your estate is now worth $2,000,000, and subject to estate taxes.  The net result: your heirs will see part of your legacy lost needlessly to the government.

There’s a simple solution that not only avoids the estate tax problem but also provides a host of other benefits.  It’s called an Irrevocable Life Insurance Trust – or ILIT for short – and it allows you to protect your loved ones without adding to your estate taxes.  Because your ILIT actually owns your policy, its death benefit won’t be taxable in your estate.  Here’s how it works.

You set up your ILIT, and name a Trustee other than yourself.  Trustees are most often the beneficiaries of the trust or a financial advisor.  The fact that you are not actively involved as a Trustee should give your no cause for concern.  Your Trustee – or Trustees – will have to precisely follow the instructions you provide in your trust documents.

After you create your Trust, your Trustee purchases a life insurance contract on your life with funds you provide.  If you have an existing policy, you can assign ownership of it to the ILIT, but there are conditions imposed on these transactions that should be carefully considered before you do so.  For instance, if you die within three years of the transfer, the life insurance contract will be included in your estate.

When you provide your Trustee with the funds to pay your annual premium, your Trustee must notify your beneficiaries in writing that a gift has been made in their names.  Your beneficiaries will have the option of withdrawing these funds from your ILIT during a specified period, usually a minimum of 30 days.  When they don’t exercise their option, your Trustee will use the money to pay your insurance premium.  This written notification of your gift to your beneficiaries is call the Crummey Letter, bearing the name of the taxpayer who won a court case against the IRS resulting in approval of this process. An annual Crummey Letter to your beneficiaries is an essential element of a successful ILIT.

Reducing your estate tax liability is a powerful incentive for considering the ILIT.  But that’s just the beginning of the long list of benefits it provides.

The ILIT provides you control over how proceeds from your life insurance policy are spent.  It is a mistake if you fail to control how the beneficiaries receive the policy’s proceeds.  Even an adult with experience may find the large sum of money overwhelming.  But when the beneficiaries are young adults who lack the maturity to handle such a windfall, the results can be devastating.

With the ILIT, you control who receives the proceeds, and how they receive it.  Whatever distribution strategy makes most sense for you and your loved ones, the ILIT gives you the opportunity to put it into effect.

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Sinclair Prosser Gasior
Sinclair Prosser Gasior
Our firm is dedicated to providing you with quality estate planning resources, so you can become familiar with all of the existing options. When you visit or call our office, we want you to feel comfortable discussing such an important issue concerning both you and your family. We want to arm you with the information you need to make an informed decision about your family’s future.
Sinclair Prosser Gasior
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