Life insurance plays a very important part in many estate plans, but proper ownership or title is critical. Many people are not aware that if you are the owner of a policy on your own life, and in the unfortunate circumstance of your passing, the death benefit is included in your taxable estate. If you have substantial life insurance, you may want to review alternate ownership possibilities or create an Irrevocable Life Insurance Trust (ILIT) to help family members manage the proceeds and potentially reduce estate taxes.
Once an irrevocable trust has been established, the grantor cannot materially change or terminate the trust and recover the assets. With an ILIT, the life insurance policies are held in the trust and the proceeds from these policies are paid to the trust upon the death of the insured or maturity of the policy. These proceeds are excluded from the estate and therefore avoid estate taxes.
Common uses of an ILIT:
Survivorship Needs and Orderly Distribution of Proceeds: This trust can be used to provide an annual income to the survivor and at the same time secure an estate for heirs. An ILIT can also help you to control the distribution of the proceeds. For example, instead of getting all the proceeds at one time, you could have your heirs receive them in installments.
Liquidity: The funds placed in an ILIT can be used to ensure that your estate has sufficient cash to pay any estate tax that may come due. At the time of your death, the life insurance proceeds will be paid into the trust. Because the estate may need these proceeds to pay estate taxes, the proceeds will need to be moved from the trust to the estate. This can be accomplished by loaning the proceeds to the estate, or by having the trust buy assets from the estate.
Wealth Replacement Trust: A common technique is to use an ILIT in conjunction with a Charitable Remainder Trust to replace the value of assets given to charity. This can result in your beneficiaries receiving much more than if you had sold the asset yourself and had paid both capital gains and estate taxes.
Irrevocable Life Insurance Trust (ILIT) Summary
- Reduce taxable estate by excluding life insurance proceeds
- Provide liquidity to estate
- Avoid probate on assets in trust
- May protect death benefit from creditors
- Can provide income to the survivor
- Cannot change or terminate trust and recover assets
- Proceeds from transferred policies included in estate unless you live for at least three years after transfer
- Trust must be owner and beneficiary of policies
- Complex legal document, need professional assistance, cost to prepare
- Value of life insurance at date of transfer is gift-taxable
What happens to an ILIT in divorce?
In the circumstance where children of the divorce are the beneficiaries of the ILIT, it may continue on after a divorce. Where cash value exists in the underlying life insurance policy it could be used to pay the premiums. Where there is no cash value an agreement must be made about how to fund the ongoing premiums.
Decisions such as these could play a significant role in your post-divorce future. Hiring an experienced CDFA will ensure a more secure, comfortable future for YOU. Make sure you sit down with one at PDM before finalizing your settlement agreement.