In talking with clients about their estate planning, one of the things we do is get an accurate assessment of all of the assets in the total estate. So, we discuss all real estate, bank accounts, stocks, bonds, 401(k)s, IRAs, vehicles, cash reserves, and life insurance.
It is not unusual for clients to forget about their life insurance policies. I think this happens for a few reasons: the policy may be very old (I have seen some purchased over 80 years ago); the policy is offered through an employer; the value may be very small; or the client thinks that the value is not included in their estate since they (the insured) is still living and therefore the policy has not paid out yet. Whatever the reason, it is very important to remember that a life insurance policy is included in the owner’s total estate as long as they have the ability to change or cancel the policy, change the beneficiary(ies), borrow against the policy, or hold other “incidents of ownership” of the policy.
Sometimes it does not matter that the value is included in the owner’s estate. For example, if the total estate, including the life insurance, is very small the owner may never be concerned about estate taxes. However, if the policy is very large, or if the owner may have an estate tax issue with or without the life insurance, then it may be necessary to consider ways to keep the life insurance but hold it outside of the taxable estate. Here is where the life insurance trust comes in handy.
An Irrevocable Life Insurance Trust (“ILIT”) is created to receive the benefits of the policy once the insured passes away. Notice that the policy is irrevocable; this is necessary to make sure the value of the policy is held outside of the taxpayer’s estate. As you establish the trust, you must determine who will serve as Trustee and you need to make sure it is funded (that the policy is titled correctly). You fund the ILIT by either transferring or selling an existing policy to the trust by naming the trustee as the owner, or transferring money to the trustee so they can purchase a new policy. Under either scenario, the trust is named as the beneficiary of the policy. This way, once the insured passes away the death benefit is paid to the trust and distributed according to its terms.
Once the policy has either been transferred or money given to the trustee, you must make sure the annual premiums are paid. According to the IRS, money used to pay the premiums is actually a gift to the beneficiaries of the trust. So, a special letter called a “Crummey Letter” must be given to the beneficiaries. This letter informs the beneficiaries that you have made a gift to the trust and the beneficiaries have a right to receive the amount gifted right now. However, the beneficiaries need to know that if they relinquish their right to the immediate income they can receive a much greater amount (the death benefit) later on.
If these rules are followed closely, the value of the policy will be outside of the taxpayer’s estate and they can still enjoy the long-term benefits of the life insurance. So, the ILIT can be a great tool for those who want to acquire or maintain life insurance but do not want to increase the size of their taxable estate.