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What is an Irrevocable Life Insurance Trust?

There are several ways to avoid estate tax on your life insurance proceeds. Estate tax is the amount assessed on your assets when you die and pass those assets to another person. Generally speaking, spouses are exempt from estate tax; however, the surviving spouse’s estate may be taxed when the children inherit.

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Estate taxes can be significant if the total amount of the estate exceeds the exemption threshold. In the past few years, that threshold, and the percentage of estate tax, has changed yearly, and the future of estate taxes and exemption thresholds is unclear.

Currently (2011) estates are taxed at 35% of any amount over $5 million. However, estate taxes have been assessed in past years at threshold amounts as low as $675,000, and the taxation rates have exceeded 55%!

Obviously, it makes sense to consider estate taxes when planning how you will leave your assets, even if your current assets are less than the threshold. One large insurance policy can push your entire estate over the limit, and can subject all of your assets to review for estate tax purposes.

How are estate taxes assessed?

Estate taxes are assessed when the owner of a life insurance policy dies and the benefits pass through the deceased’s estate. This typically happens when the owner of the life insurance policy purchases coverage on himself or herself, pays the premiums, and sets up the beneficiaries. One way to avoid this situation is to make someone else the owner of a life insurance policy in your name. If your child, for example, owns a policy on your life, estate taxes would not apply to the money passed when you die. You can fund the payments for the insurance policy, although you cannot make them directly. The disadvantage of this plan is that you have no control over the policy; your child can borrow against it or change beneficiaries at will, or may fail to keep up the payments, causing the policy to lapse.

What are the benefits of an Irrevocable Life Insurance Trust?

Another method to avoid estate taxes is to set up an irrevocable life insurance trust (ILIT). A trust is simply a document that specifies how a sum of money will be handled by giving control of the money to someone other than the beneficiary. This has several advantages.

First, if the child is a minor, he or she cannot legally take money from an insurance policy death benefit. In order to benefit the child, it is necessary to set up a trust and have a responsible adult handle the money until the child comes of age. Additionally, a trust can benefit an adult who, for whatever reason, may be incapable of handling his or her funds. A trust prevents the beneficiary from spending the money unwisely or from being duped out of it by a friend or relative, as the trustee controls when the money is released.

An irrevocable trust means that the trust cannot be changed once it is established. No matter what the insured person decides, the terms of the trust will be the same. Because the insured has no say over the distribution of the proceeds, an ILIT is not considered part of the estate—just as if the insured did not own the policy. This creates tax benefits by causing the death benefits to pass outside of the estate, exempting them from estate tax.

What are the disadvantages of an Irrevocable Life Insurance Trust?

There are some disadvantages to an irrevocable trust, however, and one must be careful in establishing an ILIT. If, for example, you buy a policy for the benefit of your adult child and set up an irrevocable trust for the money, you cannot later change your mind if you feel you would rather leave the money directly to your grandchildren. This situation may arise when an adult child is threatened with divorce or is behaving irresponsibly. Once an irrevocable trust has been created, it is difficult if not impossible to change.

One other factor that may affect your decision to create an ILIT is the time period that must elapse for it take effect. In order to prevent people from creating ILITs just before their deaths and avoid taxes, the federal government has decreed that the ILIT must be established at least three years prior to the death of the insured in order to be valid. If the insured dies prior to that three-year time period, the trust is voided and the proceeds pass through the insured’s estate. It is therefore very important that the insured create the trust as soon as practical, so that the odds will be in his or her favor of surviving the three-year period.

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