Life insurance is the primary long-term investment in our lives. But, in some cases, it can make the estate process more complicated. That’s where a life insurance trust comes into play.
A life insurance trust is a trust planned to be the life insurance’s owner or beneficiary. There are two types – irrevocable and revocable trust.
An irrevocable life insurance trust (ILIT) gives more control over life insurance policies and the money that is paid from them. It also allows policy owners to reduce or eliminate estate taxes so more of their estate can go to their loved ones.
In today’s article, we will cover the following:
- What is a life insurance trust?
- How does a life insurance trust work?
- What are the benefits of irrevocable insurance trust?
- What are the disadvantages of irrevocable insurance trust?
- What is the best way to have control over your life insurance policy?
Let’s dive in!
What Is a Life Insurance Trust?
A life insurance trust is an irrevocable, non-amendable trust that is both the owner and beneficiary of one or more policies. Following the death of the insured, the trustee invests the insurance proceeds and manages the trust for the beneficiary (or beneficiaries).
If the trust owns a life insurance policy of a married person, then usually the spouse and children are beneficiaries of the insurance trust. And if the trust owns ”second to die”, which only pays when both spouses are deceased, only the children would be beneficiaries.
Still, there is a difference between revocable and irrevocable trusts. The revocable trust gives more flexibility and control, but the life insurance death benefit value will be combined with the gross estate for estate tax purposes.
If you are not the trustee and have no considerable control, the irrevocable trust will allow you to have assets that won’t be included in your gross estate for estate tax purposes.
An irrevocable life insurance trust (ILIT) has been a universal way to set up an estate plan. It can be used to protect an inheritance for a minor child, an adult child who is inexperienced with a large sum of money, or someone with special needs.
In 2017, the Tax Cuts and Jobs Act increased the federal exemption amount to $12.06 million per person and $24.12 million per couple. After that, the popularity of ILIT dropped. It is still an open question whether ILIT makes sense or not.
Many professionals argue that it’s no longer necessary to have ILIT. They say with more money shielded from federal estate taxes, there is no reason to worry about having to pay estate taxes on the insurance payouts.
How Does Life Insurance Trust Work?
We will explain how irrevocable life insurance trusts (ILIT) work because people are more interested in them. This type of trust is irrevocable, meaning it can’t be modified, revised, or rescinded after the fact.
So, when the grantor establishes a life insurance policy inside the trust, there is no way to change the terms of an existing policy or reclaim it. This invariability is the main reason people carefully consider whether to sign a trust agreement or not.
Instead of naming an individual beneficiary to receive the death benefit, ILITs provide a few benefits to the policy owner’s heirs. With ILIT, there is more favorable tax treatment, asset protection, and a guarantee that the money from the death benefit will be used as the deceased wishes.
Wealthier people commonly use irrevocable life insurance trusts to minimize estate taxes. This can be done by making the trust the policy owner and the grantor the insured.
To avoid the problem of ownership, the trust grantor can have the trust itself apply for the policy and be the owner from the start. However, it is necessary to consult an estate planning attorney well-versed in and informed about federal tax law in this situation.
Note: A policy must be converted at least three years before the insured’s death to ensure it’s excluded from one’s taxable estate. However, it’s possible to avoid this. The trust can apply as a legal entity for the life insurance policy directly.
Here are the optimal steps when establishing ILIT:
- ILIT is completed before policy application and any premium payment.
- Grantor converts funds to ILIT for premium payments.
- ILIT trustee informs beneficiaries of Crummey withdrawal rights every time funds (or gifts) are converted to the ILIT.
- ILIT trustee applies for an insurance policy on the grantor’s life as owner and beneficiary of the policy.
In the U.S., proper ownership of life insurance is essential if the insurance proceeds are to avoid estate taxation. The proceeds will be subject to federal estate tax if the insured is also an owner. This assumes that the insured’s estate aggregate value plus the life insurance is large enough to be subject to the estate tax. Some insureds name a child or spouse (or another beneficiary) as the owner of the policy to escape taxation.
Benefits of ILIT
Thinking about death is far from enjoyable, but it’s a part of our lives, and we have to do the best we can to help our loved ones when it happens. We highlighted the benefits of having life insurance in a trust:
Minimizing Estate Tax Exposure
If you are the insured and the owner of the policy, death benefits will be considered part of your estate’s value when you die. This could expose your heirs to estate tax upon your death. For 2023, the estate tax value is increasing to $12.92 million (currently $12.06 million).
Because the trust becomes the owner of the insurance policy when put into an ILIT, the proceeds are no longer included in the insured’s gross estate. In addition, it wouldn’t be contributed toward the estate value, which minimizes potential federal estate tax exposure.
Avoiding Gift Taxes
ILIT can also be organized to avoid gift taxes on one’s beneficiaries. From its current level of $16,000, the annual gift tax exclusion will rise to $17,000 in 2023. If you use ILIT this way, insurance premiums paid to the policy inside the trust can be defined as a gift. Then you can avoid paying estate taxes by writing a Crummey Letter that says the gift is going to a trust.
Establishing Rules of the Death Benefit Payout
When the death benefit is paid out, the trust can set rules that the beneficiaries must follow. The trust document can determine only a certain amount of money per year to be withdrawn.
Or, it can establish that the proceeds can only be used for certain things (college education, for example).
These regulations can become beneficial in the case of other marriages to make sure only the insured’s children (or other beneficiaries) have a legal claim to the funds. This way, it’s guaranteed that everything will be done with the insured’s wishes or the beneficiary’s best interests.
Liquidity
One of the most important benefits of life insurance for estate planning is that the money can be used right away. If you have a property or a business, it can take months before your beneficiaries can receive benefits from it (or sell assets). But, if you have an irrevocable life insurance trust, your beneficiaries can instantly start ripping off the benefits of the proceeds.
Other benefits may include:
- Preventing life insurance proceeds from becoming part of a loved one’s estate.
- Avoiding probate court.
- Providing immediate cash to pay estate taxes and other expenses like legal fees.
- Proceeds are received free from income and estate taxes.
- Giving income to a spouse without insurance is counted as the spouse’s estate.
Disadvantages of ILIT
There is always another side to the coin. Here are the drawbacks that you have to know about before establishing ILIT.
Impossible to Make Changes
The grantor ultimately gives up all rights to the property, including who the trust beneficiaries are and under what circumstances and conditions they receive the assets, and retains no rights to revoke, terminate, or modify the trust in any material way.
And there is another problem. If you want to do it properly, you’ll need a financial advisor, a tax professional, or trusted legal counsel because the structure is complex.
Expensive to Establish and Maintain
We cannot forget the cost when deciding if an ILIT should be created. You will most likely hire an attorney to build trust, which can cost anywhere from $1,500 to $7,000 in some cases (depending on the state). Aside from creating a trust, you will have additional expenses that can cost between $350 and several thousand dollars. If you do it yourself, it is significantly less expensive but much riskier.
Many Hypothetical Scenarios
Changes in circumstances are almost certain during the time between establishing an ILIT and the date of death. Almost every year, the state changes the estate tax value and the gift tax threshold, so it’s almost like gambling on whether it will be more beneficial or not in the future.
The Ultimate Way to Have Maximum Control Over the Policy
We purchase life insurance to help and support our family and friends. And we’re always looking for the best ways to stay in control of our life insurance assets.
ILIT is a decent option to ensure benefits for your beneficiary (or beneficiaries), but there is a much more effective way to do it with more advantages. Let us introduce you to the overfunded life insurance (also known as Infinite Banking Concept).
Overfunded Life Insurance
Overfunded life insurance is a way to keep your finances under control by using a whole life insurance policy. It’s designed to allow you to build an independent financial system and cut any ties with the banks.
Instead of banks, you will profit from the Infinite Banking Concept.
You can build your own banking business and be in a position to create cash flow, lend money to others, and build generational wealth.
Why is overfunded life insurance a better option than ILIT?
To name a few reasons:
- The death benefit is tax-free. Furthermore, overfunded life insurance offers a guaranteed death benefit, tax-deferred growth, tax-free policy loans, and tax-free withdrawals.
- The cash value of your policy is liquid. You can access and use the money whenever and for any reason. Unlike with the banks, you don’t have to qualify to use your money.
- Asset protection. There are statutes that protect money in the policies. So, your funds will be safe from the reach of creditors.
- Equity. Storing your money into a policy leads to equity because the cash grows with compound interest.
- Control. You are in contol of your policy and finances in general. This applies even if something happens in the global economy (like inflation or recession).
Well, should you buy an irrevocable life insurance trust?
We will pass on it. You can benefit from ILIT, but it is too complicated, expensive, and risky.
The best way to gain control over your finances is through overfunded life insurance.
Once you build your own banking system, you will have tax-free insurance benefits, and your heirs can inherit family wealth. Moreover, you can enjoy the money while still living!
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