What Is an Irrevocable Life Insurance Trust?

by Neal Frankle, CFP ®

You should consider forming an irrevocable life insurance trust if your estate is taxable at a very high rate. How does it work?

What is an Irrevocable Life Insurance Trust

Let’s say you have a taxable estate and you figure your estate tax is going to be $500,000. Further assume that most of your estate is tied up in real estate and the family business.

If you die and the estate has to cough up the $500,000, the beneficiaries will be forced to sell real estate or the business. You don’t want either of those two things to be forced on your kids, so you consider buying life insurance to pay the eventual estate tax.

(Unfortunately, you can’t use term insurance for this – you need permanent insurance. It’s expensive, but if you have an estate tax problem, it’s much more expensive NOT to have the coverage. If you don’t have an estate tax problem but you need to protect your family…make sure you get cheap term insurance.)

Now…if you buy life insurance, you can’t be the owner. If you are, the ultimate proceeds of the insurance will be includable in your estate and subject to estate tax. No good.

Let’s say your kids are going to be the beneficiaries of your estate eventually. You could name them the beneficiaries of the life insurance, but then you would lose control over how they spend the proceeds. They could blow it in Monte Carlo once you die and still be liable for the estate tax on your assets. Ugly.

How do you protect your beneficiaries and yourself? That’s where the irrevocable life insurance trust comes in.

If this trust owns your life insurance, the death benefits are out of your estate and the proceeds will be used for their intended purpose – to pay the estate tax. As you see, an ILIT is very different from a family trust.

So why should you get started on this now? We don’t know how high or low estate taxes are going to be in the future. How is it possible to make a good decision? Well…I’m glad you asked.

If your estate is taxable at a high rate, you should consider the irrevocable life insurance trust now because:

a. It’s a good bet that you’ll be subject to estate tax

b. Assets prices are low now and will likely be much higher by the time you die (exposing you to more tax later on).

c. You are probably healthier today than you will be a few years from now

d. There is a three-year look-back and you might as well get that clock ticking now.

The three-year look-back is important. It means that if you set this irrevocable life insurance trust up but die before three years have gone by, the assets will be considered part of your estate. It defeats the whole purpose. That’s why you want to get going on this while you are young and healthy. :)

If by the time you die, estate taxes are low or non-existent, don’t worry. Your beneficiaries won’t complain about having the extra $500,000. And if taxes are higher, it’s still better to have the $500,000 to help pay the estate tax than nothing at all.

What do you think? At what point would you buy the insurance and set up this irrevocable life insurance trust?

OK…while you consider that…

Here are some reading assignments to keep you busy over the long holiday weekend:

Happy Independence Day Pilgrims!


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