The primary purpose of a life insurance policy is to provide your loved ones with financial support in the event of your death. However, under current tax law, if you are the owner of the policy the payout to your beneficiaries will be considered part of your taxable estate and therefore subject to hefty estate taxes. The irrevocable life insurance trust (ILIT) presents an option to circumvent this tax and provide more of the proceeds to your beneficiaries.
In essence, you set up an ILIT to take full control of the policy from you, thereby severing it from your estate. You give up the rights to change or designate new beneficiaries, alter payment options, borrow against the policy, or even to convert or cancel it. A separate trustee is named to administrate the policy. The ILIT can be “funded”, where you provide the trust with the funds to pay the insurance premium by transferring assets directly to the trust –note that the trust income is generally taxable to you with this method. With the “unfunded” option, the premiums are paid out of your own pocket by making annual gifts to the ILIT, thereby possibly further reducing your estate subject to a state tax.
An ILIT can also function as a shelter for your other assets, if needed, by removing those assets from accessibility by creditors or members of your family. The policy will not be subject to probate upon your passing, and the payouts may also be used to handle remaining tax debt for your family. As of 2014, the estate tax exempts $5.34 million dollars of your tax responsibility, so moving your life insurance policy to an ILIT gives you the freedom to include other components of your estate under the umbrella of this exemption.
Note that “irrevocable” means exactly that—once you set up the trust and transfer ownership of the policy, you can’t change your mind later. Be sure that the policy’s stipulations and beneficiaries are set before you employ the ILIT strategy, and be aware that the trust must be active for at least three years prior to your death in order to be excluded from estate taxes.