One of the many benefits of whole life insurance is that your death benefit passes to your heirs free of income tax. There is, however, estate tax to consider. With a large enough estate, which can include your life insurance, your heirs may see that death benefit significantly reduced anyway. One way to avoid this is to gift a life insurance policy to your heirs before you pass on. However, you’ll have to consider gift taxes if the amount exceeds your lifetime gift exemption. One solution to all of these concerns is the ILIT, or irrevocable life insurance trust.
Trusts are an important part of your financial portfolio. They help to protect your money from outside entities, make sure funds go where they’re supposed to, and can minimize taxes. If you have sizeable assets, including life insurance, it’s worth speaking with an estate planner to optimize your resources.
What is an Irrevocable Life Insurance Trust?
To define an ILIT, or irrevocable life insurance trust, we should first identify what a trust is in the first place. A trust is considered an entity, usually an unbiased third party, that holds funds and assets on behalf of your beneficiaries. The third-party operates the trust based on your wishes and can make the transfer of assets much smoother.
An irrevocable life insurance trust, or ILIT trust, is one that holds life insurance policies. This means that you can make the trust the owner of the policy, rather than yourself. Since the policy is not owned by you, there is no need to transfer ownership. When a trust is irrevocable, it’s generally not considered part of your taxable estate, which means your estate saves money on your life insurance assets.
An ILIT trust can be funded with an existing policy through a transfer of ownership, or you can use a trust to buy a new policy so that there is no transfer of ownership.
Why Should You Consider an Irrevocable Life Insurance Trust?
Let’s use a story to illustrate the power of an ILIT trust…
Imagine for a moment that you’re 55, with a 25-year-old child. You know that having a life insurance policy is powerful, yet your kid isn’t quite on board yet. Regardless, you know that this is a perfect age for them to start a policy because they’ll get a better price and lock-in rates at their current health, which is great.
Rather than having that conversation with them for the umpteenth time, you decide to buy a policy on them. You’re the owner of the policy, so you pay the premiums and make the decisions, yet you get the benefits of a policy on a 25-year-old. You also get to use the policy, so it’s a win-win. Eventually, you’ll pass the ownership of the policy to your child as a gift, when they’re likely to have a better appreciation for it. When you’re 75, you decide it’s the perfect time to pass on the gift. After all, your child is now 45 and has a family of their own.
The only problem is that when you transfer that policy to your kid, all of that cash value is considered a gift. After all, you paid those premiums until now, not your child. If you’ve exceeded your lifetime gift tax exemption, your estate may still pay taxes on transferring the asset…
…OR, you could transfer the ownership to an irrevocable life insurance trust. By doing so, the life insurance transfer won’t count toward your gift tax exemption, nor will it be a part of your estate. You can then transfer that policy knowing that you, your child, and all other heirs are optimizing this wealth transfer.
The Thing About Gift Tax
Gift taxes are taxes due on any large sum of money you gift over your lifetime, past the lifetime exemption. In addition, there’s an annual exemption, which does not count against your lifetime exemption. These taxes are a part of your estate, which means it directly affects the legacy you’re leaving to your heirs.
As of writing in 2023, gift tax exemptions are as follows:
- $17,000 a year, per recipient for a single taxpayer
- $34,000 a year, per recipient for a married couple
- $12.92 million lifetime exemption, for a single taxpayer
- $25.84 million lifetime exemption, for a married couple
So while $34,000 a year might be a pretty large gift for your children, grandchildren, or other loved ones, it doesn’t quite cover the gift of a life insurance policy. If you’re gifting a policy, that’s been in force for 20 years, the cash value is going to be a significant amount. While it depends on the initial face value of the policy, you could easily have life insurance over $1 million in cash value.
If you think you’ll be cutting your gift tax exemption close, especially if you have multiple children and/or grandchildren, an ILIT trust can take that piece off the board. By doing so, you give yourself some additional flexibility to make gifts over your lifetime. However, if the cash value exceeds your lifetime exemption at the time of your death, your estate may still owe gift taxes, even with the trust.
How to Set Up an Irrevocable Life Insurance Trust
If you want to set up an irrevocable life insurance trust, there are two ways you can do this. You can transfer an existing policy to a trust, which is governed by a trustee. Or, you can purchase a new policy using the trust, so that there is no transfer necessary.
In either case, someone must still fund the policy. As the grantor of the trust, you can fund the ILIT, yet you cannot fund the policy. Otherwise, it becomes incident ownership, and the policy can still be included in your estate. If you’re using the ILIT to transfer ownership to your child, they can fund the trust as well. Then the trustee uses the ILIT funds to pay policy premiums.
In order for the policy to stay out of your estate, you must also give up all rights to the policy. This means that you revoke your rights to change the policy, including the beneficiaries, method of payment, etc. You also forfeit the right to use policy loans. You can, however, set up the trust with certain stipulations for the trustee to uphold. In this way, you can ensure that they handle the life insurance to your standards, yet you’re not overstepping any legal boundaries.
If you intend to buy a policy for your child to use and benefit from it before gifting it, you won’t want to purchase it with the trust. The trust limits your involvement in the policy, including taking loans. However, if you transfer an existing policy to an irrevocable life insurance trust, note that you must live for 3 years after the transfer for it to be removed from your estate. Therefore, you’ll want to make the transfer when things are going well, not as a “last resort.”
Having an “end date” in mind for the use of the policy is helpful. For example, deciding to fund the policy until your child gets married, or until they reach a certain age, can give you the best of both worlds. You can use the policy for a time, and also transfer it with plenty of time to spare.
The Power of Trusts
As you can see, trusts can be powerful in your wealth-building journey and legacy planning, even with life insurance. There are, of course, different kinds of trusts, and depending on the assets you own, you might benefit from more than just an ILIT trust.
Trusts can keep assets out of probate, reduce your estate taxes, guarantee your funds go where you want them to, and even hold onto wealth for your heirs who are minors. Trusts can also help you pass assets to heirs who receive government aid so that they maintain their eligibility.
If you think you could benefit from a trust, you’ll want to work with experienced estate planners. We recommend finding attorneys near you by searching the National Network of Estate Planning Attorneys. These attorneys receive specific education, and they understand our way of Prosperity Economics thinking. Which means you can be confident they’ll help you with estate strategies that complement your use of whole life insurance.
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