A life insurance policy is usually one of the first pieces of an estate plan to be assembled. It can be considered the glue of estate planning, offering survivors the cash needed to pay off debts, taxes, funeral arrangements and legal fees following a death. It can seem odd that even though the money is inaccessible to the owner during his or her life, it still can be taxed like the rest of his or her estate at death.
An irrevocable life insurance trust (ILIT) is a specialized legal entity designed to hold the life insurance policy of its creator. By placing an insurance policy in an ILIT, a person is able to remove it from their official property and protect it from estate taxes. Though not as simplistic as owning a policy outright, ILITs can be extremely useful in reducing or even preventing tax complications at death.
Trusting with Your Life
When a person takes out a life insurance policy on his or her own life, he or she owns its ability to pay out. Even though the policy only activates at death, it pays the beneficiaries from an account the deceased technically still owns. The policy value is part of the deceased’s estate and is taxed along with all other property “controlled” at death.
In an ILIT, a creator (grantor) creates an irrevocable trust that either takes out a new life insurance policy or buys his or her current one. By placing the policy to a trust which he or she cannot control, the grantor separates it from his or her ownership. After three years, the IRS will no longer consider the trust or policy as part of the grantor’s estate.
Though the policy is outside a grantor’s control, it is still expected that he or she pay for it. ILITs can be “funded” or “unfunded.” An unfunded ILIT is only given enough money yearly to make premium payments, while a funded ILIT contains additional property designed to grow in value and cover premium costs. Since funded ILITs generate additional income tax for the grantor, they are much less common.
Premium payments put into an unfunded ILIT are considered gifts from the grantor. Typically, the yearly premium amount will fall well below the annual gift tax exemption of $14,000. Provided the trust has accounted for these gifts with special provisions called “Crummey powers,” an ILIT can be funded by a grantor without creating any new taxes.
What are Crummey Powers?
Crummey powers were created to help determine how annual gifts to an irrevocable trust would be taxed. If a trust receives small gifts annually but keeps them from the beneficiary, then the IRS will tax the total value of the contributions as a large gift when the grantor dies. Crummey powers, however, give the beneficiary the ability to withdraw gifts from the trust for a brief period of time (usually 30 days) once a year. By simply giving a beneficiary the option to withdraw a gift, the IRS must recognize that the gift was given individually that year, not all at once when the trust ends. Provided the beneficiaries cooperate and do not actually withdraw donations, the grantor can successfully pay for the trust’s premiums without incurring any gift-tax.
The Benefits to the Beneficiaries
Because an estate passes to a surviving spouse tax free, ILITs can only provide tax benefits to inheritors. Fortunately, a grantor does not need to exclude a spouse from benefits to secure the tax advantage. An ILIT can be designed to supply a surviving spouse with regular income while keeping other parties as the final beneficiaries. The ILIT supports the survivor but bypasses his or her estate, lowering estate tax obligations for the couple’s inheritors.
ILITs can also have their uses in the event of a divorce. Many courts order an individual to have a life insurance policy in order to provide child support or alimony payments in the event that he or she dies. To cover this, divorcees often take out or keep policies that simply list their ex-spouses as beneficiaries. However, if an ILIT is used, the policy can provide the necessary payments to the ex-spouse while distributing the majority to the children as a remainder. This ensures that the children, not the ex-spouse and new partner, receive the maximum benefit of the policy.
With life insurance policies always growing in value, it is becoming increasingly likely that a single policy can push a person’s estate value to the point of taxation. If drafted correctly, an ILIT can provide survivors with the money needed following a death, while reducing the impact of taxes on the property they receive. Like all trusts, ILITs require careful drafting and should only ever be created under the advisement of legal counsel. Always contact your financial advisors at MFA Asset Management or lawyer when preparing or making changes to your estate plan.
This article was written by Advicent Solutions, an entity unrelated to MFA Asset Management, LLC. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. MFA Asset Management, LLC does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. ©2015 Advicent Solutions. All rights reserved.