Irrevocable Life Insurance Trust (ILIT)
One of the
main reasons we buy life insurance is so that
when we die, our loved ones will have enough money to pay off our
remaining
debts and final expenses. We also purchase life insurance to provide for
our
loved ones' future living expenses, at least for a while. That's why it
may
seem unfair that life insurance proceeds can be reduced by estate taxes.
That's
right--the general rule is that life insurance proceeds are subject to
federal
estate tax (and, depending on your state's laws, state estate tax as
well).
This means that as much as 45% of your life insurance proceeds could be
going
to Uncle Sam instead of to your family as you intend. Fortunately,
proper
planning can help protect your family's financial security.
The key is
ownership
Generally, all
the property you own
at your death is subject to federal estate tax. The important point here
is
that estate tax is imposed only on property in which you have an
ownership
interest; so if you don't own your life insurance, the proceeds will
generally
avoid this tax. This begs the question: Who should own your life
insurance
instead? For many, the answer is an irrevocable life insurance trust, or
ILIT (pronounced
"eye-lit").
Tip: Generally,
each of us has a lifetime estate tax exemption
(tentatively $1 million in 2011 and beyond), so only individuals with
estates
that exceed this exemption amount need to be concerned about planning
for
estate tax.
What
is an ILIT?
An ILIT is a
trust primarily set up
to hold one or more life insurance policies. The main purpose of an ILIT
is to
avoid federal estate tax. If the trust is drafted and funded properly,
your
loved ones should receive all of your life insurance proceeds,
undiminished by
estate tax.
How an ILIT
works
Because an
ILIT is an irrevocable
trust, it is considered a separate entity. If your life insurance policy
is
held by the ILIT, you don't own the policy--the trust does.
You name the
ILIT as the beneficiary
of your life insurance policy. (Your family
will ultimately receive the proceeds because
they will be the named beneficiaries of the ILIT.) This way, there is no
danger
that the proceeds will end up in your estate. This could happen, for
example,
if the named beneficiary of your policy was an individual who dies, and
then
you die before you have a chance to name another beneficiary.
Because you
don't own the policy and
your estate will not be the beneficiary of the proceeds, your life
insurance
will escape estate taxation.
Caution: Because an
ILIT must be irrevocable, once you sign the
trust agreement, you can't change your mind; you can't end the trust or
change
its terms.
Creating an
ILIT
Your first
step is to draft and
execute an ILIT agreement. Because precise drafting is essential, you
should
hire an experienced attorney. Although you'll have to pay the attorney's
fee,
the potential estate tax savings should more than outweigh this cost.
Naming the
trustee
The trustee is
the person who is
responsible for administering the trust. You should select the trustee
carefully. Neither you nor your spouse should act as trustee, as this
might
result in the life insurance proceeds being drawn back into your estate.
Select
someone who can understand the purpose of the trust, and who is willing
and
able to perform the trustee's duties. A professional trustee, such as a
bank or
trust company, may be a good choice.
Funding an
ILIT
An ILIT can be
funded in one of two
ways:
- Transfer an
existing policy--You can transfer your
existing policy to the trust, but be forewarned that under federal
tax
rules, you'll have to wait three years for the ILIT to be
effective. This
means that if you die within three years of the transfer, the
proceeds
will be subject to estate tax. Your age and health should be
considered
when deciding whether to take this risk.
- Buy a new
policy--To avoid the three-year rule
explained above, you can have the trustee, on behalf of the trust,
buy a
new policy on your life. You can't make this purchase yourself; you
must
transfer money to the trust and let the trustee pay the initial
premium.
Then, as future annual premiums come due, you continue to make
transfers
to the trust, and the trustee continues to make the payments to the
insurance company to keep the policy in force.
Gift tax
consequences
Because an
ILIT is irrevocable, any cash transfers you make
to the trust are considered taxable gifts. However, if the trust is
created and
administered appropriately, transfers of $13,000 or less per trust
beneficiary
will be free from federal gift tax under the annual gift tax exclusion.
Additionally,
just as each of us has
a lifetime estate tax exemption, we also have a lifetime gift tax
exemption, so
transfers that do not fall under the annual gift tax exclusion will be
free
from gift tax to the extent of your available exemption. The gift tax
exemption
amount is $1 million.
Crummey
withdrawal rights
Generally, a
gift must be a present
interest gift in order to qualify for the annual gift tax exclusion.
Gifts made
to an irrevocable trust, like an ILIT, are usually considered gifts of
future
interests and do not qualify for the exclusion unless they fall within
an
exception. One such exception is when the trust beneficiaries are given
the
right to demand, for a limited period of time, any amounts transferred
to the
trust. This is referred to as Crummey withdrawal rights or powers. To
qualify
your cash transfers to the ILIT for the annual gift tax exclusion, you
must give
the trust beneficiaries this right.
The trust
beneficiaries must also be
given actual written notice of their rights to withdraw whenever you
transfer
funds to the ILIT, and they must be given reasonable time to exercise
their
rights (30 to 60 days is typical). It's the duty of the trustee to
provide
notice to each beneficiary.
Of course, so
as not to defeat the
purpose of the trust, the trust beneficiaries should not actually
exercise
their Crummey withdrawal rights, but should let their rights lapse.
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