People mistakenly think that because life insurance with a proper beneficiary designation form avoids probate court, no further planning is needed. Probate, however, isn't the only problem; protection from creditors and from the IRS is critical as well.
People with taxable estates, meaning assets more than their available Exemption, should consider creating a Life Insurance Trust for their life insurance. A properly drafted and administered Life Insurance Trust, sometimes called an "ILIT" for short, will remove the life insurance proceeds from the insured's estate so that the proceeds are not subject to estate tax when the insured dies.
The ILIT will have its own separate tax ID number, meaning that the Trustee of the ILIT will file a separate annual tax return for the trust. The ILIT is basically an instruction manual, which governs the ownership of the insurance and the use of the insurance proceeds if the insured dies. The insured generally won't serve as the Trustee or co-Trustee of the trust; someone independent—i.e., someone who is not a beneficiary—will act as Trustee, but the insured will have the right to fire the Trustee and appoint a new one.
The steps to create and fund the typical ILIT are relatively basic:
- Once the ILIT is drafted and signed and the tax ID number obtained, the Trustee of the ILIT completes the insurance application and opens a bank account in the name of the ILIT.
- The insured that created the ILIT gifts cash to the trust and the Trustee deposits the gift into the ILIT bank account.
- The Trustee generally needs to provide the trust beneficiaries with a letter informing them of the cash gift to the trust and giving them the right to withdraw the cash within a specified time (i.e., 45 days). This notice enables the insured to reduce and sometimes even avoid any gift tax on the gift to the trust.
- Once the time period in the notice expires, the Trustee pays the insurance premium. Each year, before the premium is due, the insured again gifts money in the trust, the Trustee sends the notification letter to the beneficiaries and, at the expiration of the withdrawal period, pays the premium.
Without the ILIT owning the life insurance, for those who die with assets more than their available Exemption, up to 40 cents of every dollar of the life insurance will potentially go to the IRS instead of to the kids who need it. Owning life insurance in a Life Insurance Trust—and following all the rules—places the proceeds outside the reach of the IRS. When the insured dies, the insurance proceeds are excluded from the decedent's assets, and they are therefore not subject to estate tax. The bottom line: Anyone with an estate that may exceed their available Exemption and be subject to estate tax should consider holding any life insurance in an Life Insurance Trust.
Call us for a consultation to evaluate whether a Life Insurance Trust is right for you.