Revocable trust and irrevocable trusts are excellent tools to be used in estate planning and the key is knowing when and how to use them, according to kake.com in “How an Irrevocable Life Insurance Trust (ILIT) Works.”
Revocable trusts tend to be used more often, since they allow for flexibility as life brings changes to the person who created the trust. However, an irrevocable life insurance trust may be a good idea in certain situations. Your estate planning attorney will help you determine which one is best suited for you.
This is how an irrevocable trust works. A grantor sets up and funds the trust while they are living. If there are any gifts or transfers made to the trust, they are permanent and cannot be changed. The trustee—not the grantor—manages the trust and handles how distributions are made to the beneficiaries.
Despite their inflexibilities, there are some good reasons to use an irrevocable trust.
With an ILIT, the death benefits of life insurance may not be part of the gross estate, so they are not subject to state or federal estate taxes. They can be used to cover estate tax costs and other debts, as long as the estate is the purchaser and not the grantor. Just bear in mind that the beneficiaries’ estate may be impacted by the inheritance.
Minors may not be prepared to receive large assets. If there is an irrevocable trust, the death proceeds may be placed directly into a trust, so that beneficiaries must reach a certain age or other milestone, before they have access to the assets.
If there are concerns about legal proceedings where assets may be claimed by a creditor, for example, an irrevocable trust may work to protect the family. A high-liability business that faces claims whether you are living or have passed, can add considerable stress to the family. Place assets in the irrevocable trust to protect them from creditors.
The IRS notes that life insurance payouts are typically not included among your gross assets, and in most instances, they do not have to be reported. However, there are exceptions. If interest has been earned, that is taxable. And if a life insurance policy was transferred to you by another person in exchange for a sum of money, only the sum of money is excluded from taxes.
An ILIT should shield a life insurance payout and beneficiaries from any legal action against the grantor. The ILIT is not owned by the beneficiary, nor is it owned by the grantor. It makes it tough for courts to label them as assets, and next to impossible for creditors to access the funds.
However, there are some quirks about ILITs that may make them unsuitable. For one thing, some of the tax benefits only kick in if you live three or more years after transferring your life insurance policy to the trust. Otherwise, the proceeds will be included in your estate for tax purposes.
Giving the trust money for the policy may make you subject to gift taxes. However, if you send beneficiaries a letter after each transfer notifying them of their right to claim the gifted funds for a certain period of time (e.g., 30 days), there won’t be gift taxes.
The most glaring irritant about an ILIT is that it is truly irrevocable, so the person who creates the trust must give up control of assets and can’t dissolve the trust.
An estate planning attorney can advise you on creating an estate plan that fits your particular circumstances and advise you on the use of trusts.
Reference: kake.com (July 19, 2019) “How an Irrevocable Life Insurance Trust (ILIT) Works”