An “Irrevocable Life insurance Trust”, which can be referred to as an “ILIT” for short is a trust that you designate to hold a life insurance policy. A life insurance trust is typically an irrevocable trust that owns insurance on the trustor (or the trustor and their spouse).
The trust is designed in such a way that the federal estate taxes on the insurance proceeds are avoided upon the death of the trustor or spouse. Insurance policies are added to your estate upon your death. Adding them to a trust removes them from your estate potentially lowering your tax liabilities. This type of trust gives you more control over insurance policies and how they are paid to beneficiaries.
How Life Insurance Trusts Work
Life insurance can be an inexpensive way to pay for any estate taxes or any other potential expenses so that you can leave more to your family. How does this work exactly, and what are some of the benefits associated with this type of trust?
Basics Of An ILIT
The way this works is simple in theory is as follows. You designate the trust as your beneficiary on your life insurance policy. When you die, the policy is paid out directly into the trust. The trustee purchases an insurance policy, with the trustor (you) as the insured, and the trust as the beneficiary.
After your death the insurance benefit is paid out. The trustee will first pay off any outstanding debts, estate taxes, probate costs, legal fees, etc. Then after those are taken care of, the remaining funds will be distributed to the beneficiaries as outlined in the trust.
Can I Transfer An Existing Insurance Policy?
Am I able to transfer an existing insurance policy (or policies) to this trust? The answer is yes. However, if you die within three years of the insurance policy transfer, it may be invalidated by the IRS. This would then be added to your taxable estate (as well as possible gift taxes). When thinking about transferring policies, they should be discussed with a financial advisor to ensure it is the correct choice.
Any Other Benefits With Insurance Trusts?
Yes, there are other benefits to naming the trust as your beneficiary. A court may take control of the money if you name someone who is not able to care for themselves as the beneficiary. An insurance company may insist upon court supervision instead of a direct payout. The trustee can use the benefits of the policy for your loved ones without court supervision if the trust is the beneficiary of the policy.
Why Not Name Someone As Owner Of My Policy?
Why should I not just name someone else as the owner of my life insurance policy? Well, there are a couple different reasons that could be detrimental. If that other party (child, spouse, etc.) dies first, then that policy becomes part of his/her estate. This would be the opposite of your intention. The goal is to reduce estate taxes, not simply transfer that liability.
Also, and more importantly, you lose control if someone else owns the policy. They could cancel your policy leaving you with no coverage, or change beneficiaries without your knowledge, etc. An insurance trust is the safer route, you have more control and helps you reduce your estate taxes.
Pros and Cons Life Insurance Trusts
A life insurance trust has a ton of benefits associated with it. It can be really helpful for your family after you have passed on. The downsides are outweighed by the control and security it provides your beneficiaries. Here are some of the most prevalent benefits and disadvantages.
Pros of A Life Insurance Trust
As we have already discussed, a life insurance trust can help reduce your estate taxes by removing the policy from your estate. Some of the other pros for this type of trust include:
Pros:
- Provides immediate cash to your beneficiaries to pay for any expenses after your death
- Gives you control over insurance policy and how the benefits are used
- Can provide your surviving spouse with income without the proceeds affecting their estate
Cons of A Life Insurance Trust
Like many irrevocable trusts, this type can be more difficult and costly to establish. It may require some professional assistance. Some of the cons for this type of trust include:
Cons:
- Setting up an ILIT can be expensive and complicated
- As with any irrevocable trust, this cannot be modified, changed or removed without the agreement of the beneficiaries
Final Thoughts: Start Planning Your Estate
At what point in the future should you set up an insurance trust? Typically, people wait until their later years around age 50s at least to consider this. Since an ILIT is an irrevocable trust and changes are difficult (if not impossible).
First, people who want to go down this route need to make sure they are still able to be insured. It gets harder the older you get, obviously. You need to also remember that there is an age requirement for the trust to be valid. Therefore, you must be alive for a minimum of three years after the transfer of the life insurance policy. It is recommended to consult with a financial advisor if you have any questions about how this works, how to get started, or if you have any other concerns.