Most people purchase life insurance to ensure their loved ones will be financially sound upon their demise. While the details of these policies vary, they generally fall into one of two categories—whole life or term. A whole life policy provides permanent coverage and has a cash value that can be “surrendered” (withdrawn) during the insured’s lifetime. A term policy has no cash value during life, may expire without paying any benefits, and pays out only upon the death of the insured. Life insurance is taxable in the decedent’s estate, and thus, a large policy can trigger unplanned estate tax ramifications.
Enter the Irrevocable Life Insurance Trust (ILIT), designed specifically to hold your life insurance policy. The ILIT is an effective tool that allows you to maintain your life insurance policy while ensuring the proceeds are not subject to estate tax. It works as follows: You are the creator of the ILIT and you designate other individuals (or an entity) as Trustee(s). You then purchase a policy in the name of the ILIT (the ILIT is the owner), but you remain the insured. The beneficiaries of the policy are those designated by you within the ILIT. Upon your passing, the value of the policy is removed from your taxable estate. Alternatively, if you have an existing policy, it can be retitled to an ILIT—if you survive three years from the date of transfer, the proceeds will not be includible within your taxable estate, and consequently, not subject to estate tax.
Besides not being taxable, the ILIT has other benefits. For example, life insurance usually pays a large amount of cash in one lump sum. However, with an ILIT, you can provide for a gradual payout. This is particularly helpful if your beneficiary is a minor child or young adult, a spendthrift, or someone not mature enough to handle a sizable quantity of cash dispersed all at once. Additionally, the ILIT provides tax-free liquidity to the ILIT beneficiaries in the event that they are faced with Federal and/or New York State estate taxes, which are due within nine months of the decedent’s death. (This is especially important if the bulk of the decedent’s estate consists of real estate.)
The ILIT also provides creditor protection. If you have debt and your policy is titled to an ILIT, the proceeds cannot be accessed by creditors upon your demise. Similarly, your beneficiary may be in debt, navigating a divorce, or receiving government benefits. Where an outright payout from your policy would otherwise be accessible to the beneficiary’s creditors or soon-to-be-former spouse, or render the beneficiary ineligible for Medicaid or SSI, the ILIT can protect against these possibilities.
The ILIT offers a myriad of benefits with no real drawback. If you have life insurance or are considering purchasing it, speaking with an experienced estate planning attorney is advisable.
