Choosing a beneficiary for your life insurance policy seems like a fairly straightforward task; most policyholders choose their spouse or children. But in certain cases, your family really isn’t the best choice.
Sometimes, an irrevocable life insurance trust (ILIT) is the safest way to protect your family. In this article, we’ll outline the different types of trusts, the benefits of naming a trust as your beneficiary, and show you how and when to set up a life insurance trust.
What is a Trust?
A trust is a fiduciary (financial) arrangement among three parties: a grantor, a trustee, and beneficiaries. The grantor “grants” the trustee permission to control assets on his/her behalf and eventually distribute assets to the trust’s beneficiaries. Trusts can be broken into two categories: revocable and irrevocable.
Much like the name implies, a revocable trust can be undone. That is to say that assets put into the trust by the grantor can be taken out by the grantor. Also called living trusts, revocable trusts allow the trustee to take over management of the grantor’s assets if he/she becomes mentally incapacitated or otherwise unable to manage their assets while they are still living. Revocable trusts are not exempt from estate taxes.
Irrevocable trusts have a number of benefits not found in revocable trusts, including estate tax protection, protection against lawsuits, and gift tax benefits, to name a few. Once assets are placed in an irrevocable trust, they cannot be removed by the grantor. They will remain in the trust until it is time for them to be distributed to the trust’s beneficiaries, weeks, months, or even years after the death of the grantor.
How Trusts Are Structured
Trusts are made up of three parties: the grantor, the trustee, and the beneficiary. But who owns what role, and how do you decide?
If you are the person providing assets or funds to purchase assets for the trust, you are the grantor of the trust. Trusts can have more than one grantor, like in the case of a married couple, in which both parties may be grantors. Examples of when this would be appropriate are if both spouses are named on insurance policies in an irrevocable life insurance trust, a couple has a second-to-die permanent life insurance policy in an ILIT, or if both spouses contribute funds to purchase assets for the trust.
The grantor of a trust cannot be the trustee and receive tax advantages. This is called “incidents of ownership.” Because you retain control of the policy, including the ability to withdraw assets (including cash value of a whole life insurance policy not in the form of a policy loan) and change beneficiaries of the policy, all the assets in the trust are considered yours. This means they are part of your estate and subject to taxes.
In order to receive tax benefits and avoid “incidents of ownership,” there must be a third party involved. A spouse (not listed as a grantor) or an adult child may be listed as the trustee, but typically a corporate trustee is appointed from a bank or trust company. Corporate trustees charge for their services, but if your estate is large enough to warrant the use of irrevocable trusts for tax purposes, it’s important to make sure you have the professional expertise to properly manage the trust and ensure your insurance policy premiums are paid on time.
If you have an irrevocable life insurance trust where insurance policies are assets, it’s typical to list the trust as the beneficiary for the insurance policies, but list your family as beneficiaries of the trust. This way, once you pass away, death benefits from any insurance policies owned go back into the trust, where they can be used to purchase additional assets and insurance policies. This is one of the best ways to create a lasting legacy with generational wealth. With this strategy, a succession of trustees should be outlined to ensure proper management over several generations.
Another benefit to keeping wealth in the trust is to help protect loved ones. If you pass away while your children are still minors, the trust can act as guardian of their inheritance until they reach adulthood. Similarly, if your spouse is incapacitated at the time of your death, the trust can manage assets on his/her behalf. Finally, wealth in a trust can be distributed to people listed on the trust’s documents in incremental payments. Depending on the asset, this can help avoid taxes. It also protects individuals who may not have the expertise to manage a large, lump sum of money.
Which Type of Trust to Choose
A revocable trust, or living trust, offers more flexibility—but less benefits—than an irrevocable life insurance trust. But you don’t necessarily have to choose one or the other. Many families choose to purchase and hold life insurance policies for family members in an irrevocable trust, but use a revocable trust for other assets like cash, stocks, or real estate.
You can still access the policy loan feature of whole life insurance policies if they’re held in an irrevocable trust—you (the grantor) decides when policy loans may be used. But a revocable trust gives you flexibility if you need to sell or move other assets, options rarely considered when it comes to insurance policies.
Remember, a revocable trust means you can cash out assets held in the trust; an irrevocable trust means your beneficiaries can cash out assets held in the trust. It’s also possible to hold the majority of your non-life insurance assets in a revocable trust and authorize the trustee of your ILIT to buy those assets with funds from policy loans, thereby moving them from the revocable trust to the ILIT at a later date.
Why Do I Need an Irrevocable Life Insurance Trust (ILIT)?
An irrevocable life insurance trust comes with several key benefits that help protect your wealth and pass more money on to loved ones. Although not every whole life insurance policyholder needs an ILIT, those with a significant estate most certainly do, as an ILIT can help reduce or eliminate estate taxes. As of 2020, any estate valued at more than $11.58 million dollars is subject to federal estate taxes. Individual states may also impose estate taxes at even lower thresholds (as little as $1 million) and vary depending on where you live.
Although life insurance death benefits are typically exempt from estate taxes, they are included in the value of your estate. If your estate exceeds state and/or federal tax limits, your beneficiary may owe taxes. An irrevocable life insurance trust helps avoid these costs, which can be significant when you consider the historical tax rate over the last decade, ranging from 35%–55%.
With this in mind, are you really leaving your loved ones the large insurance payout you had planned, or is a good percentage of it going to the IRS?
7 Advantages of an Irrevocable Life Insurance Trust
1. Minimizes or eliminates estate taxes
With an irrevocable life insurance trust, the trust owns your life insurance policies and other assets. They aren’t counted as part of your estate—an important distinction when you consider the death benefits on many whole life insurance policies may be millions of dollars, significantly increasing the gross worth of your estate. When your insurance policies are owned by a trust, you can eliminate or greatly reduce your tax liability.
2. Helps avoid gift taxes
In an irrevocable life insurance trust, contributions made by the grantor are considered gifts to the beneficiaries but typically don’t require a gift tax return to be filed. This helps facilitate the payment of insurance policy premiums for policies held in the trust and allows the grantor to contribute more funds for the trustee to use toward the purchase of additional assets.
3. Avoids probate
Unlike a will or other assets such as qualified 401(k)/IRA plans, irrevocable life insurance trusts are free from probate. This means funds are available to beneficiaries immediately after the death of the grantor, so long as the trustee has been instructed to distribute them as such. If any outstanding debts, taxes, or other end-of-life expenses are due, having cash on hand can be a significant benefit for family members.
4. Increases asset protection
Assets held in an irrevocable life insurance trust enjoy increased protection from civil suits, legal judgements, bankruptcy, and even from family members, like in the case of a divorce. Asset protections may vary by state, but generally an ILIT is one of the most secure strategies for protecting wealth.
5. Creates a path to generational wealth
One of the key advantages to utilizing an irrevocable life insurance trust for passing on wealth to the next generation is that it protects funds set aside for a child’s inheritance until they are able to manage money responsibly. By naming the trust the beneficiary of insurance policies, the death benefit pays out to the trust and is managed by the trustee while children of the grantor are still minors.
The grantor determines when and how the trust will pay out while he/she is still living. Common examples include an 18th, 25th, or 30th birthday, as payment for college tuition, for a downpayment on a first home, or the birth of a child. Payments from the trust can also be structured incrementally over time.
In the event the grantor should wish to pass on wealth to grandchildren, an irrevocable life insurance trust can help avoid the generation-skipping transfer tax (GSTT), a 40% tax imposed when a beneficiary and a grantor are more than one generation apart. Rather than passing funds directly through the trust, the grantor can provide the trustee funds to purchase additional life insurance policies and use the death benefit of the policies to funnel wealth to grandchildren and future generations, thereby avoiding the GSTT.
6. Increases control over policy proceeds
The structure of an irrevocable life insurance trust allows the grantor to specify when and how proceeds from life insurance policies owned in the trust will be used. The grantor can dictate whether or not interest or dividends from whole life insurance will be used to pay insurance premiums or purchase additional insurance, when and how policy loans are used, and when and how the death benefit will be distributed.
The trustee of an irrevocable life insurance trust helps guarantee the wishes of the grantor are met, even after they pass away. The trustee helps assets grow in perpetuity and ensures funds last to meet the needs of the beneficiaries of the trust, as outlined by the grantor.
7. Doesn’t interfere with government benefit eligibility
If the grantor has children or dependents with disabilities who qualify for government assistance, an irrevocable life insurance trust helps provide them with a steady stream of income after the grantor has passed away without putting their government benefit eligibility at risk.
Certain benefits, like Social Security and Medicaid, are based upon income. By carefully structuring distributions from an irrevocable life insurance trust, instead of one lump sum death benefit or asset transfer, the grantor ensures children or dependents maximize all available aid.
How Irrevocable Life Insurance Trusts Work
As the grantor of the trust, you have the control to decide how money is distributed and to whom; your trustee is legally bound to comply with what’s outlined in your trust documents, but once the trust is set up, your control is limited. It’s important to work with a legal team who specializes in trusts, as well as your tax accountant and insurance advisor to ensure a trust meets your needs before it is finalized.
Naming your trust as beneficiary of your insurance policies gives you control over how the death benefit of those policies are spent, so while you no longer own your policies (the trust owns them) you gain control in that you determine exactly what happens with your death benefit after you die, whether that’s buying more assets, going toward your children/grandchildren’s college education, distributed in incremental payments to family members, etc. And unlike a will, which is subject to probate and takes time to execute, your trust immediately receives payouts from your insurance company so funds can be quickly put to use.
You, the grantor, are responsible for funding your irrevocable life insurance trust. You can fund it by transferring insurance policies and other assets, which can include cash, business interests, real estate, stocks, or collectibles. You can also provide funds for the trust to purchase new assets.
In some cases, like insurance and real estate, you continually fund your ILIT by providing your trust with money to pay your insurance policy premium. Likewise, you would provide your trust with money to pay for mortgages and property taxes on real estate owned by the trust.
Transferring Existing Insurance Policies
If you already have an insurance policy and wish to transfer it to an irrevocable life insurance trust, keep in mind that if you pass away within three years of the transfer, the policy will still be considered part of your estate. This affects the taxation of your estate because the insurance policy increases the estate’s value.
Buying Insurance Policies
If you don’t already have life insurance but are considering it, whether to help build and protect your wealth or to use as your own private family bank, setting up an irrevocable life insurance trust and naming the trust as the policyholder gives you all the benefits of an ILIT without having to worry about the three-year lookback period.
Typically you apply for a life insurance policy and once it has been approved, a request for change in ownership is submitted to the insurance company, listing the trust as the policyholder. This is done before the policy is actually issued, so before premiums are paid and before the policy has accumulated any cash value. Then the policy is issued to the trust by the insurance company. The same process can be used for your spouse, children, parents or anyone else with whom you have insurable interest.
Dissolving a Trust
When a trust no longer holds assets, it is dissolved. If your irrevocable life insurance trust only holds life insurance policies and the death benefits are all distributed after you pass away, your ILIT dissolves. By this same logic, if you’re still living and your insurance policies lapse—the premiums are no longer paid—the trust would be depleted. Your trust must hold assets to remain in effect.
When to Set Up an Irrevocable Life Insurance Trust
Most people set up irrevocable life insurance trusts between the ages of 40 and 60. You want to have a good idea of what your estate will be worth, who the beneficiaries of the trust will be, and still be healthy enough to qualify for life insurance at a favorable rate. If you have existing insurance policies you wish to transfer to an ILIT, you want to do it before you’re old enough for the three-year lookback period to become a viable concern.
Your Irrevocable Life Insurance Trust Team
Your Wealth Strategist
The Wealth Strategists at Paradigm Life can help you determine how much life insurance you need for your family’s estate. They work with the nation’s top mutually owned insurance providers to find you the best coverage for your financial goals, and consultations are always complimentary. Your Wealth Strategist can also connect you with other financial and legal professionals as needed for additional help setting up your irrevocable life insurance trust.
Your Estate Planning Attorney
Trusts are legally binding documents and need to be established by a qualified attorney. The right estate planning attorney can help you choose your trustee(s) and beneficiaries and help you outline your trust so that your wishes and your family’s needs are all met. This includes determining how assets are handled, when policy loans may be used, how death benefits will be distributed, and much more.
If you already own life insurance or are considering purchasing life insurance, an irrevocable life insurance trust may help your family keep more of your hard-earned money, particularly if you have a large estate. Further, it ensures the death benefit of your insurance policy is used exactly how you wish. Trusts can be ideal ways to create a lasting legacy with generational wealth and are key tools for wealthy families. With the help of a free consultation from a Wealth Strategist and a good estate planning attorney, your family can enjoy all the benefits an ILIT has to offer.