What is a Life Insurance Trust? What does it do? In short, an irrevocable life insurance trust (ILIT):
- protects the life insurance payment from being countable in your gross estate,
- protects the proceeds from creditors and predators of your beneficiaries, and
- gives you more control over how the proceeds of your life insurance will be used after your death.
Many people have the incorrect impression that life insurance is "tax free." It is true that life insurance is income tax free, however, life insurance left to anyone other than a spouse is not exempt from estate tax.
What are Estate Taxes?
Estate taxes are imposed on the assets in your gross estate when you die. Estate taxes are different from income taxes that might be owed in the year that you die. They are also different and separate from probate fees, which might be owed to the court in which your will is probated. Estate taxes must be paid within 9 months of your date of death, whether or not the estate has been finalized, and whether or not the estate tax return has been filed.
Who Pays the Estate Tax?
The estate pays the estate tax if the gross value is more than the exempt amount set by Congress or New York State (or the state you live in). Some states have an "inheritance tax" instead of or in addition to an estate tax. The inheritance tax is imposed on the recipient of the bequest, rather than on the gross estate.
What is the Estate Tax Exemption?
The federal estate tax exemption is $5.34 million (annually adjusted for inflation). This may be sufficient to protect all of your assets from federal estate tax. However, the New York State estate tax exemption is $2.065 million as of April 1, 2014. Individuals with insubstantial assets but more than $2.165 million in life insurance may be surprised to discover that their entire estate - including the life insurance - will be subject to as much as 16% of estate taxes by New York State.
How does a Life Insurance Trust ("ILIT") save estate taxes?
An Irrevocable Life Insurance Trust (ILIT) is an estate tax savings device. The irrevocable trust owns the life insurance policies on the life of the grantor and has complete control over the policies. The policies are transferred to the trust, or the trust purchases new life insurance on the life of the grantor. Occasionally, income-producing assets are placed in the trust to pay the premiums. Alternatively, with "whole" life insurance, the income generated by the whole life insurance policy is sufficient to pay future premiums. Another possibility is for the grantor to make annual gifts to the ILIT. Since you do not personally own the insurance polic(ies) you do not have an "incidents of ownership" and the policies will not be included in your estate - your estate taxes, in turn, will be reduced.
The grantor, who is usually also the insured, surrenders all ownership interest and control in the policies. When the grantor dies, the trust collects the insurance proceeds free of estate tax. Since the insurance is not payable to the estate, and the grantor did not "own" the policies at the time of his or her death and relinquished all rights in the policies, the proceeds of the life insurance policy are paid free of estate and income tax.
Why do I need an ILIT if the federal exemption is $5.34 million, and there is portability between spouses?
The law can change at any time and the exemption may be reduced. New York State recently changed its estate tax laws on April 1, 2014, increasing the exemption but also increasing the risk that your entire estate could be subject to the tax if it is in excess of 5% over the exemption amount. Your gross estate may also increase substantially by the time you die.
Can I be my own trustee?
If your objective is to save estate taxes, you may not be your own trustee. Sometimes people name their spouse or other individuals as trustee or co-trustees. However, it is important to recognize that many people do not have the time, experience, or understanding necessary to fulfill the fiduciary obligations of a trustee. Sometimes people choose a corporate trustee (a bank or trust company) who can make sure that the trust is properly administered and the insurance premiums promptly paid.
A trust sounds complicated. Can I name someone else as the owner of my insurance policy? Why can't I just name the nominated guardian of my kids?
If someone else such as your spouse owns your policy at your death and dies first, the cash/termination value (of a whole policy) will be in his or her taxable estate, which doesn't solve the problem. If you and your spouse switch ownership of each other's policies, and you both die in a simultaneous disaster, then both policies will be taxed. More importantly, if someone else owns the policy, you have no control over those assets or how they are used. They will be taxable in that person's estate and subject to that person's creditors and predators, including their spouse if he or she becomes divorced. This person could change the beneficiary, take out the cash value, or even cancel the policy and leave you without any insurance. If you pick a trustee with whom you are on good terms at the time you choose them but later have a falling out, this could very well happen. You may trust the person now, but have problems later on. An ILIT allows you reduce estate taxes while still keeping some level of control.
