How Can An Irrevocable Life Insurance Trust Be Funded?
An Irrevocable Life Insurance Trust (ILIT) is a legal entity created to own a life insurance policy on the life of the grantor, who is usually the person establishing the trust. Once established, the grantor cannot amend or revoke the trust. The trust is the policy’s beneficiary while the grantor is alive, and after the grantor’s death, the trustee distributes the policy proceeds according to the trust’s terms.
Life insurance is an essential tool that can provide financial security for surviving family members and liquidity of assets upon death. However, the use of life insurance in estate planning can be problematic from a tax perspective. Life insurance proceeds paid to a beneficiary upon the insured’s death are usually not subject to federal income tax. Still, they may be included in the value of the decedent’s gross estate and may be subject to federal and state estate tax if payable to the estate or heirs.
To exclude life insurance from the estate and minimize or eliminate estate tax liability, an ILIT can be used. The trust purchases the policy, or the policy can be transferred to the trust. The trust document appoints a trustee to administer the trust’s assets and designates beneficiaries and the terms of their benefit. Since the trust is irrevocable, it cannot be altered once established.
|Advantages of ILITs||Disadvantages of ILITs|
|– Lower federal and state estate taxes|
– Asset protection against creditors
– Increased asset control
|– Potential for gift taxes|
– Inability to change the trust agreement
– Three-year waiting period before gross estate exclusion applies
The three-year waiting period prevents a grantor from making an abrupt transfer of assets to a trust before death to avoid estate taxes. Therefore, planning for the estate and establishing an ILIT as early as possible is crucial.
For example, John had a $4 million home and a $1 million insurance policy when he passed away in 2021. His gross estate value was $5 million, which is below the federal estate tax exclusion amount for 2021. However, Vermont’s estate tax exclusion is only $5 million in 2021, so John’s estate would be liable for state estate tax. If John had established an ILIT more than three years before his death, his policy would be excluded from his gross estate, valued at only $4 million, and eliminating federal and state estate tax liability.
ILITs have advantages and disadvantages, and it is essential to understand them before establishing one.