The main purpose of buying life insurance is to reduce the burden of dues or funeral from the shoulder of our loved ones after death. But, the part of life insurance where many people lack awareness about estate taxes.
These taxes reduce the payment of life insurance, and people are clueless about the reduction.
It was bad news for many, but the good news is that it is avoidable. Before you go further to know about life insurance, you must know about irrevocable life insurance trust and estate taxes.
What are the Estate Taxes & Inheritance Taxes?
Estate or inheritances become subject to taxation after someone’s death. It is calculated based on the property owned by descendants at the time of death. Similarly, inheritance tax is the one that is payable by the beneficiaries of the property of a descendant.
The estate tax is different from the income tax. These taxes are to be paid within 9 months after you die. Usually, it is paid through the cash as given the conditions from the Estate.
Who Has to Pay These Taxes?
The whole estate tax scenario changed in 2001 when Federal tax law amendments eliminated the credit. As a result, many states canceled their estate tax.
However, few states are still collecting the estate tax, and those are the ones with more than $11.4 million value.
Most people don’t have to worry about the estate taxes as many states are not liable to pay the federal estate tax. It is because many states are too small to reach the value above the given before.
So, here comes the irrevocable life insurance trust for the people who want to avoid these estate taxes. Or if they don’t want to make their beneficiaries liable for any inheritance or estate taxes.
Now, what is ILIT?
ILIT is specifically to take control of the insurance policies or policy while a person is alive along with the dues that are to be paid to the beneficiary after the death of the insured. This trust will serve as both beneficiary and owner of the policies.
It is also known as estate planning. Most people who want to avoid the estate tax on their passing and don’t want to put their beneficiary under some obligation, they use ILIT for it.
So, when any beneficiary is liable for the estate taxes, ILIT serves in between as a middle man to help them pay the taxes in cash without reducing the value of life insurance. You can also call it estate tax shielding.
What Does Life Insurance Trust Do?
An irrevocable life insurance trust is supposed to provide you with complete control over your life insurance policy reducing the estate tax from it. It is even the way to eliminate the estate taxes from life insurance in an exchange of any assets worth the taxes.
With ILIT, you will fund the trust and trust will pay your premiums of life insurance. This way the total amount of your life insurance or any other benefits of it will remain the same. So, estate taxes are either reduced with it or eliminated.
How does it work?
The trusts own your insurance making sure that the value of it is not reduced by paying estate taxes. Mainly it is formed on 3 components. The grantor (you), a trustee and a beneficiary.
So, the trustee purchases the life insurance with you being insured. After your death, the trustee will collect all the funds including debts, taxes or anything due. Later, the trustee will distribute the rest of the value of life insurance to the beneficiary.
Benefits of ILIT for family
Most people ask about the advantages when taking such important decisions. Some will scare you off in the beginning by explaining the downsides of it. However, it is totally up to your planning and how you manage it to benefit from it. Well, some of the greater benefits of ILIT are as follows:
The foremost purpose of the trust is to avoid estate taxes. Now, when you don’t own the ownership of the assets, you will not have to pay the estate taxes when you die. There are a few of the things that you might want to consider.
For example, transferring the policy into it can lead you to a problem if you within 3 months of it. So, the recommended step is to have your trust to purchase a policy. In this case, the estate cannot null and void the transfer in any way.
Protection of Possessions
It benefits you when you are sued by someone and he/she wins. With an irrevocable trust, they may not be responsible to cover the damages, but benefits to your heirs remain the same. It is because trust is a distinct entity of you. So, your assets are safe in this matter too.
Manageable Cash Flow
Giving up the ownership of your property doesn’t mean that you cannot get benefits from it. So, if any income is produced by those assets, the properly planned trust will provide you with a deserving income from it.
Since your assets are not treated as your possession even when you die. So, probate is easily avoidable. It bypasses the probate process after your death and without any hassles.
Now, when you know all the benefits, you might be thinking about how to set it up and plan wisely.
How to Setup ILIT?
First of all, keep in mind and understand it well that any assets transferred to the trust will no longer be under your ownership.
So, plan it carefully and after putting every possible thought in it. Few are the steps that might help you in setting up ILIT more precisely.
- Select the trustee.
- Create an irrevocable trust agreement (a legal document).
- Get a taxpayer identification number.
- Be aware of the latest estate laws about registration of trust and other requirements.
- You may require other legal documents for transferring the assets.
So, overall, you will need a financial advisor to follow the legal process without any flaws and hassles.
Key Obligations of the Trustee
The benefits like asset protection, benefits for the beneficiary and avoiding the taxation or probate clearly shows why you need to use ILIT.
Moreover, knowing the trustees’ responsibilities and creating an agreement while keeping them in consideration is necessary for the successful and desirable outcome from it.
Other than opening and maintaining the trust checking account, a trustee will be responsible for:
- Purchasing the life insurance policy
- Funds acceptance from a grantor
- Paying premiums to the life insurance company
- Filing of tax returns if required
- Claiming insurance after your death
- Distributing funds as per the agreement
When to Use ILIT?
Now, many people may still have some reservations about using the ILIT. It is natural for anyone to think about it again and again.
So, if you want to set any of the assets aside for estate taxes or any other purposes, you must use ILIT right on the time. It just needs to be planned properly and to consider every point at the time of the agreement.
It benefits the beneficiaries too as the court cannot find a link of them to any of these assets, so they cannot hold them for any estate tax or other obligations of the property.
Also, if your beneficiaries are minor, they will only be able to receive the value of life insurance or assets if they are responsible.
It all depends on the terms of the agreement, so you have complete control over the life insurance with ILIT planning.
What are the Downsides of ILIT?
Everything that comes with the advantages also share some downsides. The world is merely an experimentation lab. So, anything including ILIT is beneficial as well as has some drawbacks.
Planning and structuring the ILIT precisely and according to your requirements is necessary. There are also a few drawbacks of the ILIT, so while taking the decision, you must know about them. I
t will make it easy to decide, and you can find out the ways to manage it properly.
- You will not have any control. Trustees of the trust will have all the power.
- You may not necessarily need it. Many estates have no liability for the taxes because of exemption value rising above their actual value.
- The 3-year lookback rule can be a potential drawback. So, watch out for it at the time of planning.
Before planning ILIT, you may need to know about your estate laws and policies. Many states are not even liable for the estate taxes, so ILIT may give you no benefit.
However, if you live in an estate that is more valuable than the exemption gift, you may need to consider all the benefits along with the downsides of ILIT.
Mainly it has most benefits especially if you want to secure the future of your beneficiaries.