Estate Planner's Arsenal: The Irrevocable Life Insurance Trust

The "Estate Planner's Arsenal" series highlights specific estate planning tools and their uses.

An Irrevocable Life Insurance Trust ("ILIT") is a relatively straightforward estate planning tool that is used primarily for reducing or avoiding estate taxes, as well as maintaining more control over the disposition and use of your life insurance proceeds after your death.  An ILIT can be a useful tool for someone with a taxable estate with large life insurance policies, or the ability to qualify for a large life insurance policy.  

Estate Taxes.  Without detailing the various available deductions, people who die with an estate over $5.25 million (2013) will be subject to the federal estate tax.  Perhaps more common, people who die with an estate over $1 million (2013) will be subject to the Minnesota estate tax.  Life insurance policies are an asset that people frequently overlook when they are calculating the total value of their estate.  It's important to understand that the face value of a life insurance policy on your own life will be included in your estate for estate tax purposes.

Ownership.  If you have "incidents of ownership" over a life insurance policy, it will be included in your estate.  Generally speaking, "incidents of ownership" means that you retain some control or rights regarding the insurance policy.  Here is where the Irrevocable Life Insurance Trust comes into play.  By transferring complete ownership of the life insurance policy into the Trust, you are able to remove the value of the life insurance proceeds from your estate.  Note that you must survive for three years after the transfer to have the proceeds avoid federal estate taxation.  You can also have the Trust purchase new life insurance policies on your life - and have these policies kept out of your estate immediately.  The beneficiary of the life insurance would be the Trust.  

ILIT Uses.  I've previously discussed in detail the many important uses that life insurance has in estate planning.  Life insurance proceeds create larger inheritances for your heirs.  They are available shortly after your death.  They are an inexpensive and liquid way to pay for the administration and expenses of your estate, including any estate taxes owed.  By placing life insurance policies into an irrevocable trust, you not only reduce estate tax liability, but you also retain greater control over the disposition of the proceeds.  At your death, the proceeds can be distributed to the beneficiaries of your choosing and for the purposes of your choosing.  For instance, you can provide your spouse with income for life - thus keeping the full proceeds from your spouse's taxable estate.  You can have the trust retain the proceeds and make distributions as needed for your beneficiaries, such as your children or grandchildren.  Further, money that remains in the trust is protected from the creditors of your beneficiaries as long as it is in the trust.

Paying the Premiums.  Your trust pays the life insurance premiums through annual gifts that you make to the trustee.  You can give up to $14,000 ($28,000 if a spouse joins) (2013) tax-free to the trustee for the benefit of the beneficiaries.  The trustee then notifies the beneficiaries that they have the right to withdraw that money for a specific period of time.  If the beneficiary does not take the gift, then the trustee uses that money to pay for the life insurance premiums.  Amounts left over would be retained in the trust.  Therefore, it's important for the beneficiaries of the trust to understand the circumstances of the gift, so that the premiums are paid and the policy does not lapse.  

This article is a general outline of the uses of an irrevocable life insurance trust.  Speak to an estate planning attorney if you want to learn more about how an Irrevocable Life Insurance Trust may work with your particular circumstances.