You may think of life insurance in very simple terms. You buy a policy so that your loved ones will have some financial assistance when you die; but, its functionality doesn’t end there. If it looks like your accumulated wealth will be subject to estate taxes someday, life insurance may be a very useful tool for you, especially when it is used in conjunction with trusts.
What does a life insurance trust do? An Irrevocable Life Insurance Trust ("ILIT") enables you and your family to do a few things. First, it can provide funds through life insurance proceeds to meet the needs of trust beneficiaries and, in some cases, your estate. Second, it allows proceeds to be distributed based on the grantor’s pre-determined wishes, or it can leave this discretion to the trustee, subject to the terms of the trust. Last, but certainly not least, it gives you the chance to reduce your estate taxes. Generation-skipping transfer taxes may also be a consideration for your estate, but are beyond the scope of this article.
When you create a life insurance trust, you are creating a separate entity (the trust) to own life insurance policies. Since the trust owns the policies rather than the insured individuals, and the proceeds are payable to the trust upon the insured’s death, the insurance proceeds aren’t subject to probate, income taxes, or estate taxes. A trustee can then distribute these proceeds to one or more parties as stipulated in the language of the trust. For example, some families may want to delay an heir from legally receiving an inheritance until they reach a certain age.
Additionally, if your estate is of substantial value and needs more cash to pay estate taxes, the ILIT can help provide this liquidity in a couple of ways. The trustee can either purchase assets from the estate for cash or can loan cash to the estate to help pay any additional estate taxes. The trust can be drafted in various ways to accomplish your goals.
Who pays for the insurance? As the grantor (i.e., the creator) of the trust, you have a say over how premiums are paid. A grantor can pay the premiums directly; this act is not defined as an "incident of ownership" that will cause inclusion for estate tax purposes, but this isn’t typically done. In most cases, the trust pays the premiums; the grantor transfers enough funds into the trust to allow for payments to come directly from the trust itself. ILITs are usually drafted with withdrawal rights, known as Crummey powers, that allow the gift tax annual exclusion to apply to these transfers so that they may be able to pass to the trust without gift tax liability. Sometimes another party pays the premiums instead, although this can cause gift tax issues as well. Some grantors just pay a lump sum for coverage – that is, they buy a single premium life policy.1,2
A life insurance trust generally must abide by certain requirements. First, it needs to be irrevocable. That is, once created it is legally "set in stone," unlike a revocable trust which can be amended or revoked later on. Second, you (the grantor) should not be named as trustee; someone else you trust should serve in this role. Finally, transferring an existing policy that you own into the trust has to done at least three years prior to your death.3 If the trust purchases a new policy, the three year lookback does not apply. Violating these requirements may cause estate inclusion and increase your estate tax liability.
Why don’t I just have someone else own my insurance policy? This scenario can lead to major financial and familial headaches. If that person predeceases you, the cash value of the policy will be included in their taxable estate. So, the heirs of that person could face unforeseen estate taxes, or at least higher estate taxes than they now anticipate. Also, if you do this, you surrender control of your policy; the loved one you trust could end up naming another beneficiary or even cashing your policy out.3
A decision for life. Establishing an ILIT is a big decision that can result in a big estate tax break for your heirs. If you’d like to know more about these trusts and their potential, talk to a qualified legal, financial, or insurance professional today.
To learn more about life insurance trusts, contact a Boulay advisor at 952-893-9320 or learnmore@BoulayGroup.com.
Investment Advisory Services offered through Boulay Financial Advisors, LLC a SEC Registered Investment Advisor. Certain Third Party Money Management offered through ValMark Advisers, Inc. a SEC Registered Investment Advisor. Securities offered through ValMark Securities, Inc. Member FINRA, SIPC 130 Springside Drive, Suite 300 Akron Ohio 44333-2431* 1-800-765-5201
Boulay PLLP and Boulay Financial Advisors, LLC are separate entities from ValMark Securities, Inc. and ValMark Advisers, Inc. Prime Global is not affiliated with ValMark Securities, Inc. and ValMark Advisers, Inc.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
1 - nolo.com/legal-encyclopedia/life-insurance-trusts.html [9/3/14]
2 - fidelity.com/viewpoints/personal-finance/can-life-insurance-help [11/6/13]
3 - nolo.com/legal-encyclopedia/transfer-life-insurance-decrease-estate-tax-29585.html [9/3/14]
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