What it means
If you own a life insurance policy on your own life, the death benefit is generally added to your estate for estate tax purposes. For a wealthy family, that can push the estate over the tax threshold, and the tax may then take a large share of the payout.
An ILIT avoids this by taking ownership of the policy. The trust is irrevocable, which means the person who sets it up cannot change it or take the policy back, and so the proceeds are kept out of the estate when they are paid.
The trust can be set up to buy a new policy, which is the simplest route, or to take over an existing one. In the United States, if an existing policy is transferred and the insured dies within three years, the proceeds are generally pulled back into the estate, which is why many advisers prefer that the trust buys a new policy directly.
Because the trust owns the policy, it needs money to pay the premiums. The insured usually makes annual gifts to the trust, and the trustee notifies the beneficiaries of their right to withdraw those gifts for a short period, a feature often called a Crummey power, which helps the gifts qualify for the annual gift tax exclusion.
The trust document controls who receives the money and when. A trustee might pay it out in stages, hold it for young children, or use it to provide cash so that heirs do not have to sell a family business or property to pay estate taxes.
The main cost is loss of control, along with legal fees and the need to run the trust properly. Rules differ by country and change over time, so anyone considering an ILIT should take advice from an estate planning lawyer and a tax adviser.
In practice
Real-world examples.
Example
A business owner worth $15,000,000 wants her children to inherit the company without a forced sale. She sets up an ILIT that buys a $3,000,000 policy, and the proceeds will provide cash to pay estate taxes.
Example
A surgeon creates an ILIT for his spouse and children. He gifts the premium to the trust every year, and the trustee sends a letter to each beneficiary giving them a short window to withdraw the gift.
Example
A retired executive realises that her old whole life policy is inflating her taxable estate. After taking advice, she transfers it to a trust and understands that she must survive three years for the plan to work.
Formula
Calculation
Estate tax avoided = Death benefit x Estate tax rate (if the benefit would otherwise be taxed in the estate)
Assume a founder has an estate that already exceeds the tax-free threshold, and the top estate tax rate applying to additional value is 40%. She holds a $2,000,000 life policy personally. If she owns it, the extra tax is 2,000,000 x 40% = $800,000, leaving $1,200,000 for her family. If an ILIT owns it from the start, the full $2,000,000 reaches the trust free of estate tax, a saving of $800,000, less the cost of running the trust.Case study
Seen in the real world.
Whitestone Family Foods is an illustrative, fictional family business that the founder, Marcus, wanted to hand on to his two daughters. His estate was mostly the company and some property, with little cash, and he worried that the daughters would have to sell the company to pay estate tax.
His adviser proposed an ILIT that would buy a $4,000,000 policy on Marcus's life. Marcus gave the trust $60,000 each year to pay the premium, and the trustee managed notices and records carefully.
When Marcus died many years later, the trust received the $4,000,000 outside his estate. The trustee then bought some of the estate's assets and lent the estate part of the money, so that the daughters could pay the tax without selling the business. The illustrative lesson is that cash arriving at the right moment can be as valuable as the money itself.
Watch out
Common mistakes.
- Transferring an existing policy and assuming it is immediately outside the estate, when a three-year rule can bring it back in if the insured dies too soon.
- Paying premiums directly from the insured's account instead of through gifts to the trust, which can blur the ownership and risk the tax treatment.
- Naming the insured person as trustee, which would give too much control and may defeat the purpose of the trust.
Questions
People also ask.
Can I change an ILIT once it is set up?
No, it is irrevocable, so you generally cannot change the terms or take the policy back, which is why the design must be carefully considered at the start.
Who should be the trustee of an ILIT?
A trusted adult who is not the insured, or a professional trustee such as a bank or trust company, is usually chosen.
Is an ILIT worth it for everyone?
Not necessarily, because it is mainly useful where the estate is large enough for tax to apply, and the costs and loss of control must be weighed against the savings.
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