You’re not likely to be asked to serve as the trustee of an irrevocable life insurance trust (ILIT), which is a trust designed to reduce estate tax. Under current law, most people don’t need to worry about federal estate tax, which affects only the wealthiest one-half percent of estates. (Some states also impose their own estate taxes, but they don’t take such a big bite out of the estate.)
But with the uncertainty that’s surrounded both federal and state estate taxes for years now—will the exempt amounts go up? go down? will the taxes go away completely?—some people have created these trusts just in case.
Estate tax is imposed on all the assets a person owned at death—which includes a few surprising items, such as the proceeds of any life insurance policy the person owned. Those proceeds can add a sizeable amount to the value of one’s estate. It’s not uncommon for someone who earns a good salary to buy $1 million of life insurance, for example. Adding that amount to an estate could push it over the exempt amount (currently $5 million), making the estate liable for federal estate tax.
Using a life insurance trust lets a wealthy person take the life insurance out of his or her estate. It’s simple: Transfer ownership of the insurance policy to a trust, and you don’t own it anymore. And at your death, the proceeds won’t be part of your taxable estate.
A life insurance trust is a legal entity that the policy owner sets up while he or she is still alive. Its only purpose is to own the life insurance policy, so that the proceeds won’t be part of the former policyholder’s estate. The person who sets up the trust, called the settlor, can’t keep any rights over the policy at all. For example, once the policy is transferred to the trust, the settlor can’t change the beneficiary or get at the cash value of the insurance policy.
In order for the trust to deliver the estate tax benefits, certain IRS rules must be carefully followed:
The trust must be irrevocable. The settlor who transfers the life insurance policy to the trust can’t change his or her mind later and revoke the trust.
The settlor can’t be the trustee. Every trust must have a “trustee”—someone to manage and control trust property. With an ILIT, someone other than the settlor must be the trustee and have complete control over the life insurance policy (the only trust property). Some settlors name a spouse or adult child to serve as trustee.
The trust must be set up at least three years before death. Someone who’s looking to avoid estate tax can’t make an ILIT at the last minute and avoid a big chunk of taxes. If the trust hasn’t been in existence for at least three years before the settlor’s death, the proceeds of the life insurance policy are included in the settlor’s estate for estate tax purposes.
When the insured person dies, the policy proceeds are paid to the trust. The money is managed or distributed according to the terms of the original trust document. For example, the trust might direct the trustee to keep the money in the trust until the surviving spouse dies, and then distribute what’s left to the children.
Expert help from an experienced lawyer is needed to draw up a valid life insurance trust, and legal advice is a must or anyone who's given the job of acting as trustee for such a trust. You don't want to do something that runs afoul of IRS rules and ends up thwarting the tax-saving goal of the trust.