Most American adults are aware that they should have life insurance, particularly if they have minor children or other dependents. Life insurance does provide a large measure of security for families. However, people often fail to consider the fact that an insurance policy is considered part of a decedent’s estate. If the value of the estate exceeds the applicable exclusion amount under the law, the estate will have to pay death taxes. In many cases, a large insurance policy is what pushes the estate into this territory.
In addition, the proceeds of a life insurance policy are paid to beneficiaries at one time. Beneficiaries who are unprepared to manage this large amount of money may spend it imprudently, leaving themselves destitute. Beneficiaries with special needs who formerly qualified for means-tested government benefits may have needed services withdrawn because receiving the insurance proceeds means they no longer qualify.
Fortunately, there is a solution that can avoid all of these outcomes: an irrevocable life insurance trust (ILIT).
How an Irrevocable Life Insurance Trust Works
When you create and fund an irrevocable life insurance trust (ILIT), it becomes the owner of your life insurance policy or policies, removing ownership from you. Because the trust is irrevocable, meaning you can’t resume ownership, the proceeds of the policy are payable to the trust, and they stay out of your estate. This creates a number of benefits for your estate and your beneficiaries.
One such advantage is that by keeping the proceeds of your life insurance policy out of your estate, the size of your estate is reduced, perhaps significantly. This could reduce or eliminate your estate tax liability. In addition, having your life insurance in an ILIT may actually reduce the amount of life insurance you need to have, because the policy proceeds will not be needed to pay estate tax.
Control is another benefit of having an ILIT. As with other types of trusts, an ILIT allows you to dictate the circumstances, timing, and amount of distributions from your trust. You also decide who will serve as trustee to oversee the management and disbursement of funds. If your life insurance policy is not held in a trust, your beneficiaries who are legal adults will receive full disbursement of their share when the policy is paid out. If they invest or spend it unwisely, the financial protection you intended to provide them evaporates.
The control offered by an ILIT extends to protection from creditors, both before and after your death. If your policy has a cash value, having your life insurance held in an ILIT protects the cash value of the policy from being seized by creditors during your lifetime. After your death, the terms of the trust may also provide protection to your beneficiaries by preventing their creditors from reaching trust assets.
If any of the beneficiaries of your life insurance policy receive Medicaid or certain other government benefits, receiving policy proceeds outright could disqualify for them for benefits, requiring them to “spend down” their assets before they can again become eligible for these programs. Having the insurance policy held in an ILIT, by contrast, keeps ownership of policy proceeds out of your beneficiaries’ hands, and preserves their eligibility for benefits.
Other Considerations Regarding Irrevocable Life Insurance Trusts
Policyholders should be aware that if they fund an irrevocable life insurance trust (ILIT) with an existing policy, the Internal Revenue Service will still consider the policy part of their estate for the purposes of calculating estate tax for three years from the date of transfer into the trust. In addition, using an existing policy for an ILIT may trigger gift-tax considerations. However, if you have an existing policy, you have nothing to lose by transferring it into an ILIT.
If you choose, as many people do, to first create the ILIT and then to fund it with a new policy, you may use an individual life insurance policy or, if you are part of a married couple a “survivorship” policy, which insures the life of two people and pays the death benefit upon the death of the second person.
You should also be aware that if you are the named on a life insurance policy that is held in an ILIT, you may not also serve as the trustee. Your estate planning attorney can help you identify an appropriate trustee for your irrevocable life insurance trust.
The estate planning attorneys of Ortiz & Gosalia, PLLC have post-JD degrees in tax law and can help you to establish, fund, and select a trustee for your irrevocable life insurance trust. With offices in Redmond, Bellevue and Kirkland, we offer services throughout the Seattle area and Washington State. If you would like to learn more about irrevocable life insurance trusts, we invite you to contact us.
Life Insurance