Today, we’re diving deep into the world of estate planning to discuss a topic that often raises eyebrows: the Irrevocable Life Insurance Trust, commonly known as an ILIT.
What is an ILIT?
An ILIT is an irrevocable trust specifically designed to hold and own life insurance policies. Once a policy is inside the trust, it’s out of the insured’s taxable estate, ensuring that the death benefit isn’t subject to estate tax upon the insured’s death.
Why is this important?
Many people mistakenly believe that life insurance proceeds are not taxable. While it’s true that the beneficiary typically doesn’t pay income tax on the proceeds, the value of the life insurance policy is counted towards the gross estate of the deceased for estate tax purposes.
For context, the federal estate tax affects all states and has been around since World War I, primarily as a revenue generator for Congress and various governmental programs. Additionally, 12 states in the U.S. have their own estate tax. For instance, Massachusetts has an estate tax threshold set at one million dollars, though there are considerations to raise it to two million dollars in the near future.
How does an ILIT work?
Think of an ILIT as a treasure chest. You transfer the ownership of your life insurance policy into this chest (the ILIT). By doing so, you’re essentially telling the tax authorities, “I don’t own this policy personally. My trust does.” This move ensures that the policy isn’t counted in your taxable estate.
However, there are rules to follow:
Trustee Selection: The trustee of the ILIT should never be the person insured. Their role is to manage the insurance proceeds and distribute them to the beneficiaries.
Crummy Letters: The trustee is required to send annual letters to beneficiaries, informing them about the trust’s assets and giving them an opportunity to claim a portion of those assets.
Three-Year Look-Back Period: If you transfer an existing life insurance policy into an ILIT, there’s typically a three-year look-back period. This means that if the insured dies within three years of transferring the policy to the ILIT, the policy will still be counted in the taxable estate.
This rule is in place to prevent “deathbed transfers.” However, if you purchase a new policy and
place it in the ILIT immediately, this rule doesn’t apply.
ILITs are a powerful estate planning tool, especially for those with significant life insurance policies. They can help reduce or even eliminate estate taxes on life insurance proceeds. If you’re considering setting up an ILIT, it’s essential to consult with an estate or elder law attorney to ensure it’s the right move for your situation.
For more insights into estate planning and elder law, we’d love to see you at an upcoming workshop, or check out our Elder Law Academy to learn about important legal matters from home at your own pace.