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How Does an Irrevocable Life Insurance Trust Work?

MP900430727An irrevocable life insurance trust (ILIT) can provide tax benefits, protect assets and ensure that asset distribution takes place as the benefactor wanted. It may sound formal, but it’s a useful tool in estate planning and may be worth considering.

Any irrevocable trust is just that: irrevocable, meaning that it cannot be changed. An irrevocable life insurance trust (ILIT) is a trust that owns a life insurance policy. And once this trust is created and the life insurance policy is placed in the trust, no changes can be made.

As an alternative to designating an individual beneficiary, ILITs offer several legal and financial advantages to heirs. This includes favorable tax treatment, asset protection and the assurance that the benefits will be used in a manner concurrent with the benefactor's wishes.

Investopedia’s recent article, “When Is It a Good Idea to Use ILIT Trust?” says that there are several advantages to ILITs, including state tax considerations, the protection of fiscally-careless beneficiaries from squandering their payouts and the prevention of courts and creditors from accessing the assets.

An ILIT is often used to set aside assets for certain purposes, like paying estate taxes, because these assets themselves aren’t taxable. To do this, the selected assets must be moved into the life insurance trust at least three years before they’re used. If you use a qualified estate planning attorney to create this, the death benefits paid to the ILIT won’t be included in the gross estate of the insured. This is different than when life insurance death benefits are paid to an individual, because the proceeds are included in the taxable estate of the decedent.

The ILIT also has asset protection for the beneficiaries, if they are involved in a lawsuit. That’s because ILITs aren’t considered to be owned by the beneficiaries. This makes it hard for courts to connect the assets to the beneficiary, making them nearly impossible for creditors to access.

There are some drawbacks to using an ILIT, so carefully consider the pros and cons of creating one. Changes to an ILIT can only be made by the beneficiaries. As a result, the benefactor loses control of the assets prior to death. ILIT assets are also not taxed as part of the estate, but they are taxed as part of the beneficiaries' estates, leaving a bigger tax burden to their descendants.

An ILIT is not a simple legal matter. There are strict rules from the IRS that must be followed to ensure that the ILIT is done correctly. Otherwise, it may create problems for heirs. An estate planning lawyer in your state who is experienced with ILITs will be able to determine if this is the right tool for your estate plan, and then work with you to put one into place.

Reference: Investopedia (August 5, 2019) “When Is It a Good Idea to Use ILIT Trust?”