An irrevocable life insurance trust (ILIT) is a specific type of legal arrangement that falls under the umbrella of trusts.
Trusts, in general, are legal instruments that involve property being held and managed by a trustee for the benefit of a beneficiary. Trust property can consist of assets such as money, real estate, investments, and more.
There are several types of trusts with a wide range of purposes and terms, but they can primarily be categorized as either revocable or irrevocable.
A revocable trust can be altered, amended, or revoked by the settlor, also known as the trustor or grantor, who is the person responsible for creating the trust.
Changes to a revocable trust can happen at any point in time. In contrast, an irrevocable trust is unchangeable and cannot be modified or revoked once its terms are established.
An irrevocable life insurance trust is specifically designed to hold a life insurance policy as its trust property. The primary purpose of an ILIT is to prevent the taxation of death benefits paid by the life insurance policy.
Beneficiaries of a life insurance policy typically do not owe taxes on the death benefit, as it is not considered taxable income. However, if the life insurance proceeds are not immediately paid out upon the policyholder’s death, the survivors may face estate taxes on the policy proceeds or interest taxes if the insurance company retains the proceeds after the policyholder’s death.
How Do I Set Up an Irrevocable Life Trust?
Setting up an Irrevocable Life Insurance Trust (ILIT) typically involves these steps:
Hire an Attorney
Consult with an experienced attorney who handles estate planning and life insurance trusts. They will be able to guide you through the process and ensure that your trust is set up correctly.
Choose Your Beneficiaries
Decide who you want to receive the death benefits from your life insurance policy. The beneficiaries will be named in the trust agreement.
You can name family members, friends, or charities, or you can name the trust itself as the beneficiary.
Your attorney can assist you in drafting the trust agreement and naming the beneficiaries. They can help you consider factors such as tax implications, estate planning goals, and potential legal issues that may arise.
When naming beneficiaries, be specific and include their full names and relationship to you. This will help avoid confusion or disputes later on.
It is also important to name contingent beneficiaries in case your primary beneficiaries predecease you or are otherwise unable to receive the death benefits.
It’s a good idea to review and update your ILIT periodically to ensure that it continues to meet your estate planning goals and that the named beneficiaries are still appropriate.
Choose Your Trustee
Select a trustworthy and competent trustee to manage the trust assets and distribute the proceeds to your beneficiaries. The trustee can be a family member, friend, or a professional trustee.
Draft the Trust Agreement
Work with your attorney to draft the trust agreement, which will outline the terms and conditions of the trust. This will include how the life insurance proceeds will be managed and distributed, the powers and duties of the trustee, and the rights and responsibilities of the beneficiaries.
Transfer Ownership of the Life Insurance Policy
To fund the trust, you will need to transfer ownership of your life insurance policy to the trust. The trust will become the policy owner, and you will no longer have any control over the policy.
To transfer ownership of your life insurance policy to an Irrevocable Life Insurance Trust, you will need to:
- Contact your life insurance company: Notify your life insurance company that you want to transfer ownership of the policy to an ILIT.
- Obtain the necessary forms: Your insurance company will provide you with the necessary forms to complete the transfer of ownership. These forms will vary depending on the insurance company and the type of policy you have.
- Fill out the forms: Complete the forms provided by your insurance company, including the name and details of the trust, and sign them.
- Submit the forms: Send the completed forms to your insurance company, along with any additional documents they may require.
- Wait for confirmation: Your insurance company will review the forms and, once approved, will confirm the transfer of ownership to the trust.
Once the transfer of ownership is complete, the trust will become the new owner of the life insurance policy, and you will no longer have any control over the policy. The trust will be responsible for paying the policy premiums, and the trustee will manage the policy’s proceeds according to the terms of the trust agreement.
You will need to file paperwork with the insurance company and the IRS to notify them of the ownership transfer and establish the trust.
Fund the Trust
Once the trust is established, you will need to make sure it is properly funded by making annual gifts or contributions to the trust.
What are Some Benefits and Limitations of Irrevocable Life Insurance Trusts?
The primary advantage of an irrevocable life insurance trust is its ability to protect the life insurance policy’s death benefits from being taxed. In addition, an ILIT enables the policy owner to retain legal control over the life insurance policy.
For example, the policy owner can appoint a trusted family member as the trustee to manage the life insurance proceeds for minor children until they reach the age of majority, which is typically 18 years.
Another advantage of an irrevocable life insurance trust is that it can provide a way to protect the life insurance proceeds from creditors, lawsuits, and other claims. This can be especially beneficial for those with a high net worth or those who work in professions that are more susceptible to lawsuits.
Without an ILIT, the interest earned on the life insurance proceeds might be taxable to the beneficiaries if the death benefits are not immediately paid out upon the policy owner’s death.
Other advantages of establishing an ILIT include preserving beneficiaries’ government benefits. Life insurance proceeds might be considered income for the beneficiary, potentially affecting their eligibility for income-based government assistance such as Medicaid. An ILIT’s trustee can ensure that the life insurance proceeds do not interfere with the beneficiary’s government aid.
A significant drawback of an ILIT is its inflexibility; once established, the trust’s beneficiaries and terms cannot be altered. This rigidity poses some risk to the settlor, with the reward being the avoidance of taxes on the estate or beneficiaries.
Beneficiaries cannot borrow money from an ILIT, and the life insurance policy owner cannot be named as a beneficiary or trustee within the trust. Consequently, the insured must appoint another trusted person, such as an attorney or accountant, to serve as the ILIT’s trustee.
While these professionals’ services can be expensive, the tax savings associated with an ILIT often outweigh the costs of hiring a qualified trustee and establishing the trust.
Do I Need an Attorney for an Irrevocable Life Insurance Trust?
The creation of an Irrevocable Life Insurance Trust can be complex, but the benefits for the beneficiaries and the policy owner are significant.
It’s best to seek the counsel of a skilled and knowledgeable trust attorney to determine whether this type of trust is appropriate for your needs. With their knowledge, they can examine your estate and insurance policy and assist you in identifying the optimal legal strategies for minimizing estate taxes.
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Use LegalMatch to connect with a qualified trust lawyer who can advise you on your trust issue and potentially represent you in court, saving you both time and money.