Irrevocable Life Insurance Trusts*

An Introduction

This introduction is the first of a multi-part series on an extremely important planning tool -- the Irrevocable Life Insurance Trust (often referred to as an ILIT).  The ILIT is not as simple as it appears at first glance.  It has the potential to blow up if it isn't 1) based on sound counseling, 2) drafted well, and 3) implemented with precision.

In future issues, we'll discuss the procedures that must be followed every time an ILIT is used, what to do with existing policies, the differences between individual and joint ILITs, how ILITs impact annual gifting programs, the famous "5 and 5" limit, the risks when estate taxes are paid from the proceeds of an ILIT, generation skipping, and choosing proper trustees.

The Big Picture

Life insurance is a critical tool in estate planning.  Life insurance proceeds create liquidity at precisely the time it is needed to pay the expenses of a person's final illness and death -- and to pay estate taxes if necessary.

In addition, life insurance provides cash for beneficiaries of estates that are asset-rich, but cash-poor.  A family business owner may use it for beneficiaries who are not involved in the business.  In a second marriage, one spouse may use it to provide for the other, while preserving the bulk of the estate for children.

Life insurance payable to a designated beneficiary avoids probate (unless the estate of the insured person is erroneously named as the beneficiary). If life insurance is not owned correctly, however, or if premiums are not paid in the most tax-efficient manner, gift and estate taxes can reduce the benefits of life insurance policies by approximately half!

Many people believe that life insurance is exempt from all taxes.  This is not true.  They may remember an advisor telling them that they "won't pay taxes" on the life insurance proceeds.  The advisor, of course, had federal income tax in mind.  Income taxation is separate and distinct from estate taxation.  And if you own life insurance, the death proceeds will be subject to federal estate taxation and perhaps state estate taxation, depending on the state in which you live.

As long as the insured person has any rights or powers over the policy (referred to as "incidents of ownership" in the Internal Revenue Code), the proceeds will be included in his or her estate for estate tax purposes.

To avoid this problem, a life insurance policy can be purchased by, or contributed to, an irrevocable trust.  The insured person cannot be a trustee or beneficiary of that trust because both control by a trustee and enjoyment of benefits as a beneficiary would constitute incidents of ownership.  Instead the irrevocable trust (an ILIT) becomes both the owner and the beneficiary of the policy, and the insured person chooses trustees to manage it.

We often think of life insurance in the context of paying estate taxes.  However, even those estates that will never be large enough to be taxable will probably include insurance policies purchased for other reasons.  By having those policies owned in an ILIT, the estate has more room for growth.

More next issue...

*Adapted from the Planning Partners Press.