Today, life insurance is more than just insurance, it is an important asset. In fact, your life insurance policy may have a cash value to it, thus making it an asset with a real monetary value. Even if it is a non-cash value policy, a life insurance policy is an important asset because you rely on it to provide income and support to your family when you die. Moreover, life insurance is highly recommended as a tool to pay estate taxes and other liabilities such as mortgages that are due at death because death benefit funds will be available immediately to your survivors without any delays or expenses involved with liquidating tangible assets.
If You Do Nothing, the IRS May Get Almost Half of Your Policy
The greatest misconception most clients have when it comes to life insurance is that the proceeds are estate tax free. This is absolutely wrong! The proceeds are income tax free … but estate taxes are worse than income taxes. After the exemption amount, estate taxes quickly rise up to 40%!! Thus, if you and your spouse have an estate over the exemption amount when you die, you could lose 40% of the proceeds to Uncle Sam. Why lose potentially hundreds of thousands of dollars after you paid those premiums so diligently when a simple trust can take the IRS out of the picture and provide better protection for your beneficiaries?
What the Irrevocable Life Insurance Trust Is
An irrevocable life insurance trust (ILIT) is simply an irrevocable trust which has a life insurance policy as an asset. Like all other irrevocable trusts, the ILIT requires a written document, a trustee, a beneficiary, and the terms of the trust distribution. A properly drafted ILIT should also have in its preamble that the purpose of the trust is tax savings by utilizing a particular life insurance policy.
In essence, the ILIT owns a policy which insures your life. The policy itself will name the trust as beneficiary so when you die, the insurance company pays the proceeds to the ILIT trustee. Then the ILIT trustee will follow your trust instructions on what to do with the proceeds, including paying the ILIT beneficiaries you named in the trust document. The trust must make all payments of premiums. You can gift funds into the trust each year to pay for the premiums.
An ILIT Can Save You Big $$ In Estate Taxes
In short: simply by setting up an ILIT, you can save hundreds of thousands if not millions of dollars in estate taxes! An ILIT saves you estate taxes because the ILIT, rather than you personally, owns the life insurance policy. Because the policy is not owned in your name, the policy proceeds will not be part of your net estate when you die. Thus, they will not be subject to the estate tax. This can save your family a lot of money. Consider this example:
Let us assume that you are single when you die and that your estate will be worth $20 million at the time of your death, $2,000,000 of which is life insurance. Let us also assume that you have the full amount of your $5,450,000 estate tax exemption when you die. Because the first $5,450,000 of your estate is exempt from tax, your estate will have to pay taxes on the remaining $14,550,000 — an estate tax bill of over $_________________________ (14,550,000 x 40%) under current tax rates! By using an ILIT, you can get that $2,000,000 of life insurance value out of your estate, thereby saving your family almost $800,000 in estate taxes!
In this way, if you would ordinarily be in a 40% estate tax bracket, you can effectively more than double the amount of proceeds your beneficiaries get from the policy by using an ILIT. You are simply taking the IRS out of the equation … legally.
An ILIT Also Gives You Control
The ILIT gives you much more control over what happens to the policy proceeds than you would get from a bare insurance policy. With an insurance policy alone, your only decision is who to name as beneficiaries, and the insurance company will simply pay these people when you die. Life Insurance carriers typically offer only a few settlement options. With an ILIT, on the other hand, you can control not only who gets the proceeds, but even more importantly, you can customize exactly happens to the funds when you die.
An ILIT can provide that the trustee will pay costs, such as probate costs, legal fees, other debts, etc., before paying any trust beneficiaries. You can have the trustee pay the beneficiaries directly or pay them over a period of months or years. You can incorporate spendthrift provisions and anti-alienation provisions to protect against your beneficiary’s (children) financial problems, creditors, or their spouse in the event of divorce. In fact, an ILIT gives you all of the benefits of a trust arrangement while allowing you to provide for your family just as you would with a bare insurance policy.
For these reasons, an ILIT should be used to own almost every life insurance policy and one can readily see why they are a vital part of a client’s estate plan.