Death is certain, and you want to make sure your spouse, children, and others dear to you are properly cared for when your time comes. The purpose of life insurance is to provide for your loved ones when you pass on, and it does this by paying out a lump sum to them upon your death.
Unfortunately, federal and state taxes can defeat the purpose of holding a life insurance policy. If it pays out more than a certain amount, heavy estate taxes will apply, and your legacy will be reduced to a shadow of what it once was. One way to keep this from happening is to place your policy in an irrevocable trust, known simply as an irrevocable life insurance trust, or ILIT.
IRREVOCABLE TRUSTS AND LIFE INSURANCE
Placing your life insurance policy in trust can remove it—and its payout—from your estate. It does this by essentially holding ownership of it for you. In other words, the trust, not you, owns the policy, and therefore you cannot be taxed for it. This benefits you by reducing the size of your taxable estate, keeping it below the threshold where heavy taxes would tear it to pieces.
It’s important that the trust be irrevocable. In a revocable trust (which you can modify after its formation), the assets it holds are still considered to be part of your estate, so it does nothing in terms of reducing those taxes. Irrevocable trusts, on the other hand, cannot be modified once they are set up, so you aren’t considered to be the owner of the assets (like your life insurance policy) placed therein.
A FEW POINTERS
Of course, to function properly, your ILIT must be correctly structured. It should also be set up at the right time since poor timing can render its benefits completely null. A few pointers in setting up an irrevocable life insurance trust include:
- Set it up early: If you die within three years of setting up the trust, the life insurance proceeds are moved back to your estate, essentially rendering the trust useless. To prevent this, set up the ILIT any time you get a new policy.
- Choose a trustee wisely: Naturally, the trustee should be someone you completely trust. It can’t be you, but it can be virtually anyone else, including a parent, sibling, or close friend.
- Plan and prepare carefully: Everything needs to be set up in the right way and in the right order. Otherwise, the IRS will likely challenge the trust and render it pointless.
- Make sure you’re insured: The policy is intended to insure you, so make sure you are listed as the insured party and not the policy holder or applicant when applying for life insurance. This will make sure the death benefits are paid out to your beneficiaries without attaching ownership of the policy to you.
Throughout the process, you will need the assistance and counsel of an experienced estate planning attorney. Hart & David can provide the guidance you need to set up your ILIT properly and make sure it safeguards your assets.