I was asked to present on this topic this past month, and I thought I’d share the results of my research.
An irrevocable life insurance trust (otherwise known as an ILIT) is a resource that can be used to avoid estate taxes, and/or to provide a means to pay for them. Here’s how it works:
Normally, when the estate tax is calculated, life insurance is included as part of the estate. When life insurance is placed in an ILIT, however, it is considered separate from your estate and is not subject to the estate tax. By using an ILIT, you can pass money on to your heirs tax-free, or you can use the money to pay some of the estate tax bill on the rest of your estate.
That’s how an ILIT works. But how do you go about setting one up?
First, you create the trust. You want to distance yourself from the trust as much as possible – the more control you have over it, the more likely the IRS will consider it part of your estate. To limit your control, you’ll have to make it irrevocable, so that you can’t make any changes once it’s in place (with some limited exceptions). You’ll also need to choose a third party to be the trustee. In most cases that will be the successor trustee of your primary trust, but some people choose to have a bank or professional fiduciary instead.
The next step will be to put the life insurance in the trust. While you can put an existing policy in an ILIT, it’s generally recommended to have the trustee apply for a new policy on your life once the trust is in place.
Once that’s done, you will need to pay the premiums. It’s generally recommended to make an annual payment into the trust, which the trustee then uses to pay the premiums on the life insurance. This can be set up as an automated payment, which makes things easier for everyone.
It is possible to make these premiums qualify for a gift tax exclusion. To do this, you need to give the beneficiaries a “present interest” – in other words, they have to have the right to withdraw funds from the trust. To give them this right, the trustee needs to send them a notice each time a payment is made into the trust (another reason to make the payment annually instead of more frequently). The notice should tell them how much they’re allowed to withdraw, the time window they have to request the withdrawal, and why it’s a bad idea to actually ask for the money. After all, it would defeat the purpose if you deposited exactly enough money to pay the premiums and a beneficiary then demanded his share of the money from the trust.
If an ILIT is set up and implemented correctly, it can serve as a great tool to minimize taxes in a large estate. To learn more about ILITs, or to find out if they would be a good idea for your estate, please email me at email@example.com.