What is an Irrevocable Life Insurance Trust (ILIT)?

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Many individuals are unaware that the proceeds from their life insurance policies may be included in their estates for tax reasons after they die. Depending on the policy’s value, this might result in an estate tax liability. It is, however, preventable. It is not an unbreakable rule, and there are exceptions. If you want to assume ownership of the policy, one alternative is to create an Irrevocable Life Insurance Trust, commonly known as an “ILIT.”

What Is an ILIT, Exactly?

An ILIT is a special sort of living trust designed to own a life insurance policy. After the ILIT is founded, you may transfer ownership of an existing policy to the trust, or the trust can acquire the policy directly.

However, you are unable to function as the trust’s trustee. The trust must be irrevocable, which means you must “fund” it by transferring ownership of the policy to it and then stand away. You must give up any right you have to amend or dissolve the trust.

Acting as a trustee would provide you with “incidents of ownership,” which would enable you to keep control of the policy. However, you may appoint a trustee to be your spouse, adult children, a friend, or even a financial institution or an attorney. When you create trust, you may name anybody you choose.

What Are Ownership Incidents?

You may take the policy’s cash value or modify the beneficiaries at any moment throughout your life if you owned it and had control over it. The proceeds of the policy would therefore be included in the valuation of your estate by the IRS and certain state taxation authorities since it would be your asset.

If the proceeds are large enough, your estate may be subject to estate taxes. That is true if your estate is the insurance’s beneficiary, but even if you designate your son, daughter, husband, or someone else as the beneficiary, the policy would still be an asset of your estate if you owned it at the time of your death.

Taxes on estate

As of 2021, the estate tax exemption amount is $11.70 million per estate. Only the portion of an estate’s worth that exceeds that amount is subject to taxation.

You would surpass this exemption if you insured your life for $5 million, and your other property was worth more than $6.7 million at the time of your death. Any worth above the $11.70 million thresholds would be subject to the estate tax, which would be owed by your estate and, by extension, your heirs.

Federal estate taxes affect only the wealthiest estates, although several states have their own estate taxes with far lower thresholds. If your state’s exemption is $1 million, the remainder of your policy’s benefits, along with the amount of your estate, might put it into the taxable territory.

Who Are the ILIT Beneficiaries?

The ILIT is usually named as the principal beneficiary of the insurance policy. When you die, your death benefits are put into the ILIT and kept in trust for the benefit of the people you selected in your trust paperwork to receive the money.

Your spouse would get monthly incremental payments rather than a flat amount if the proceeds were held in trust for their benefit. They would not be taxed as part of their estate as they would be if the lump amount was given to them directly, presuming the funds had not run out by the time they died.

Complications that might occur

If you pass away within a period of three years of transferring your life insurance policy to your ILIT, the IRS will still register the proceeds in your estate for estate tax purposes. You may prevent this by having the Trust buy the policy on your life and then providing the Trust with enough money to pay the premiums over time.

Because you are basically giving the Trust the money to pay for the policy each year, gift taxes may be a factor, but this can also be avoided.

Every time you transfer money to the Trust, your trustee may simply send a “Crummey” letter to the Trust’s beneficiaries. This letter would inform them that they may request their portion of the funds within a certain time frame. The gift tax does not apply if they have an immediate entitlement to the money.

Of course, the amount you are donating to the Trust pales in comparison to the ultimate proceeds of your policy, especially if it is split among numerous beneficiaries. The premiums will be unpaid if they accept the money now, and the policy will expire.

This is generally enough to persuade the beneficiaries to leave the money with the Trust so that the policy may be paid for.

The Trust's Dissolution

After you have established an irrevocable Trust, you usually can not change your mind. However, since the life insurance policy requires continued premium payments, all you would have to do to terminate the Trust would be to cease paying the premiums. When the policy expires, the Trust will be left with nothing.

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