Life insurance is a financial asset that is widely used to help protect your family from expenses after your death. However, what most people don’t realize is that even though life insurance is designated to a specific beneficiary, that doesn’t mean it’s exempt from estate taxes or that it will be used according to your wishes. In fact, life insurance proceeds are included in your estate for federal estate tax purposes and are considered an asset when calculating the total value of your estate.

Adding to this potential financial burden is the fact that estate taxes are required to be paid to the IRS within just nine months of the date of death. Although immediate federal estate taxes on life insurance can be delayed if your beneficiary is your spouse, the taxes will still be owed upon their death, when tax rates are likely to be higher and the burden will be placed upon your children or heirs. But there is a way to avoid this expensive and stressful outcome.

Irrevocable Life Insurance Trusts
The best way to use your life insurance investment, protect your assets and provide for your family without overpaying taxes on your funds, is to set up an Irrevocable Life Insurance Trust (ILIT). An ILIT is an irrevocable trust that owns your life insurance, pays the premiums, and is your beneficiary.  Through the use of an ILIT, a number of estate planning objectives can be achieved:

• Insurance proceeds are free of estate tax upon your death and the death of your spouse
• The instructions you provide in the trust document allow you to direct the payment of insurance proceeds for the care of your beneficiaries
• The life insurance and proceeds are asset protected during your lifetime from creditors, predators, and in some cases – from marital claims
• The life insurance proceeds received by an ILIT are available to pay the death expenses, including taxes, for both you and your spouse

How does an ILIT work?

Identify a Trustee
The first step in an ILIT is identifying an independent Trustee to manage the ILIT, receive gifts from you for the payment of insurance premiums, send out notices to beneficiaries, manage the policies and pay the required premiums. In many cases, the Trustee may be your attorney as they have no benefit in the outcome or assets of the trust.

Purchase Life Insurance for the Trust
In most cases, the ILIT will purchase a specific life insurance policy on you and it will also be the beneficiary of this policy. The Trustee may also purchase a policy, naming the beneficiary as the ILIT, so long as you do not retain any “incidents of ownership” in that policy, meaning you cannot retain control over the use of the policy or it will be considered a part of your estate. You may also transfer existing life insurance policies into the ILIT, but there is some risk involved with this. If you die within three years of gifting existing policies into the ILIT, they will still be included in your taxable estate.

Pay Your Premiums
In order to pay the premiums for life insurance every year, you gift the appropriate amount to the Trustee of the ILIT.  Gifts to an ILIT are normally subject to the federal gift tax, however, the tax can be avoided by giving your beneficiaries what is called a “demand right.”  When you make a gift to the ILIT, your Trustee will send a noticication to your beneficiaries which states that they are entitled to take their share of the gift out of the ILIT during a limited period of time after the gift is made (usually 30 days). When the time period has expired, the trustee will then use those funds to pay the life insurance premiums. While giving your beneficiaries this right to the funds may seem foolhardy, if you explain the purpose of the ILIT and that the small premium payments now will result in a much larger investment in the future, there are usually no issues. We have only had one instance where a beneficiary exercised their demand right to withdraw the gift.

Distribute the Funds
At your death or the death of your spouse, the life insurance funds in the trust provide the ability to pay any taxes and end-of-life costs that are necessary. The trustee can also use proceeds from the ILIT to purchase assets from your estate or Revocable Living Trust, so that the estate is able to pay any outstanding expenses. For instance, your ILIT may purchase a vehicle, real estate or other asset from your estate, meaning your ILIT retains the asset, but the cash becomes available for your estate to cover any necessary expenses. The proceeds of these sales are also exempt from income taxes. The funds can also be distributed to your heirs, according to your wishes and explicit instructions for the trust.

Protect Your Assets and Your Heirs
By creating an ILIT, you ensure that your life insurance funds are protected from creditors and predators, that your family avoids probate at your death, and that the funds will not be included in your estate for federal estate taxes. Your heirs will have the benefit of tremendous flexibility for the funds upon your death rather than a very large tax bill to be paid to the Internal Revenue Service. Establishing an ILIT is a complex estate planning tool that accomplishes many objectives but it should be discussed in detail with your attorney and financial advisor.