There are many different kinds of trusts available, almost all of which are designed to remove assets from your estate and pass them on to your heirs or charitable organizations with minimal tax consequences.
One of these options is the irrevocable life insurance trust (ILIT). For certain people it may accomplish a number of estate objectives, but may not be appropriate for everyone. Below are answers to four common questions people ask about ILITs.
What Is an ILIT?
An ILIT is created by you, the grantor, during your lifetime. The ILIT owns a term or permanent insurance policy on your life. You may fund this trust by transferring ownership of an existing life insurance policy, or by contributing cash on an annual basis to pay the premiums on a new policy purchased by the ILIT.
As the grantor, you designate beneficiaries, usually family members, who will typically receive the proceeds upon your death.
The trust is irrevocable, meaning that you forfeit all rights to the property contained in the trust.
What are the benefits of an ILIT?
The ILIT may be able to help you accomplish several estate objectives, including:
- Meeting liquidity needs;
- Managing estate taxation on the policy proceeds; and
- Providing income to survivors.
How does an ILIT work?
When you die the trust receives a payment equal to the policy coverage amount. Since the trust is irrevocable, the proceeds are not considered to be part of your estate, which can potentially shield them from estate taxes.
Your ILIT should be set up to provide direction about how and to whom payments may be made. For example, you may direct the trust to pay out cash to cover certain expenses, such as your funeral costs, probate, taxes, final medical expenses, and debts. This may eliminate the need for your survivors to sell less-liquid assets—such as your home or business—at an inopportune time to cover such costs.
Your trust’s beneficiaries may then receive any leftover proceeds, creating an inheritance free of estate taxes.
Finally, these assets should be shielded from creditors since they belong to the trust, not you.
What are the risks of ILITs?
Using any kind of trust involves a complex set of tax rules and regulations.
One specific risk of an ILIT is that transfers of existing life insurance policies into an ILIT are subject to the IRS’s three-year rule. This rule stipulates that if you die within three years of transferring your life insurance policy into an ILIT, the value of the policy may be added to the value of your estate at the time of your death, rather than be removed from it. This essentially would eliminate one of the main benefits of the ILIT. That’s why you may not want to establish an ILIT if you’re at an advanced age or have medical conditions that might result in your death within the next three years.
Several factors will affect the cost and availability of your life insurance, including age, health, and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. If your policy is surrendered prematurely, you also may pay surrender charges and face income tax implications. You should consider determining whether you are insurable before implementing a strategy involving life insurance. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.
Creating an ILIT should be done only with the assistance of a qualified estate planning attorney. It is a complicated exercise in which mistakes may result in losing the benefits ILITs offer.
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Dan Flanagan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or dflanagan@canbyfinancial.com
The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright 2021 FMG Suite.