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ILITs Remain a Popular Estate Planning Tool
and Technique
The federal estate tax may or may not be repealed or reformed
anytime soon. But such discussions in Washington should not
dampen the use of irrevocable life insurance trusts as a still
very viable and valuable planning tool and technique which has
applications beyond the tax efficient payment of estate taxes.
Indeed, financial planners say irrevocable life insurance
trusts, or ILITs, can fulfill many estate-planning goals, not
the least of which is avoiding federal estate taxes on the death
benefit amount of the life insurance policy. By way of
background, there are two major types of trusts: revocable —
which
can be changed as often as you want — or irrevocable — which
generally cannot be amended or changed without the permission of
a court, and then only for limited purposes. These trusts can
either be funded (assets that will produce premium dollars are
put in the trust) or non-funded (premiums are contributed
annually). Typically, a person would either transfer an existing
insurance policy on their life into a trust (or have a trust
purchase a new insurance policy) if they were interested in
controlling the distribution of the death benefit in a manner
beyond the ability of the contract provisions to do so, if they
wished to remove the proceeds from their taxable estate, or, in
some cases, beyond the reach of the creditors of beneficiaries.
As the name suggests, an ILIT is a trust that cannot be
changed or revoked by the creator or "trustor" once it
is executed. Generally the trustee cannot be changed, the
beneficiaries or the terms of the trust cannot be changed, and
assets in the trust cannot be removed by the person who created
the trust. By way of contrast, a revocable trust can be changed by
the trust's originator, beneficiaries can be added or removed,
assets can be withdrawn, and the trust can be terminated.
In general, here's how it works: The life insurance trust is
created first, and then the trust buys a life insurance policy
in its own name on the trustor. The trustor, in an unfunded
trust, annually adds funds to the trust, which in turn, buys
(and continues to pay for) the policy in its own name, and pays
the policy's premium against its own account. An independent
trustee is generally required in this case if "incidents of
ownership" of the life insurance policy are to be avoided
on the part of the person creating the trust.
It is possible to transfer an existing life insurance policy
to such a trust however; in this case, the policy death benefit
will remain part of the trustors' estate for three years after
the transfer. It's important that the trustor irrevocably
relinquishes to the trust absolutely all control over the
policy. It's best to work with an estate planning attorney when
creating an ILIT.
In essence, the trust takes over ownership of the policy. The
trustor then makes contributions to the trust, which, in turn,
uses the contributions to pay the policy's premium against its
own account.
As mentioned, a major reason for an ILIT is that the assets
in the trust — the proceeds of the life insurance policy or the
face value after the insured dies — will not be included in
insured's taxable estate at their death. As long as they do not
retain any incidents of ownership in the life insurance policy,
the proceeds should not be taxed in their estate. Most people
will use an irrevocable life insurance trust if they anticipate
that their assets will be above the applicable exclusion
amount (and, thus, subject to tax).
But having assets pass outside on a taxable estate is just
one reason for using an ILIT. The combination of life insurance
and a trust assures the management, investment, and timing of
that wealth. And it does so with a great deal more flexibility
than the name might suggest.
The combination of life insurance and trusts have amazing
creditor protection potential — far more than either alone. Once
an individual has parted with (or never owned) life insurance
and it's safely in an irrevocable trust containing the proper
"spendthrift" provisions, it's almost impossible for
the creditors of the beneficiaries to reach it. In other words,
one of the most effective ways to assure the financial security
and future of loved ones (or a charity) is life insurance in an
irrevocable trust.
The combination of life insurance with a trust can avoid the
costs, delays, and aggravation of probate — not just once — but
over several generations. The life insurance/trust combo offers
flexibility impossible to achieve through life insurance alone —
while the life insurance in the trust makes a much larger and
therefore more economical/practical/cost effective trust
possible and in most cases is the only instrument capable of
providing a benefit at precisely the time it is needed.
In addition, cash payments to an irrevocable life insurance
trust may qualify for annual gift exclusion. In order to
qualify, beneficiaries of the irrevocable life insurance trust
are given what are called Crummey powers or "present
interest rights" to the monies which when structured
correctly will be declined by them so that the monies can be
used to pay premiums.
As a reminder, it's best to work with an estate planning
attorney when creating an ILIT.
July 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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