Life insurance can give great peace of mind to the insured by providing for their loved ones after their death. Life insurance benefits can help pay for your children’s college education or provide for your surviving spouse. However, life insurance policies can cause estate planning issues that outweigh the benefit of the policy.
Posted on October 29, 2016
When you die, everything in your name at the time of your death is considered to be part of your estate, including any death benefit proceeds from a life insurance policy, for estate tax purposes. Life insurance benefits are often sizeable, so this can greatly increase the estate taxes owed on your estate. Another potential issue with a life insurance policy is that you do not have control over when and how your beneficiaries will receive the policy proceeds. Your beneficiaries will receive an immediate lump sum upon your death. This lump sum inheritance could also disqualify your beneficiary from government assistance programs. Additionally, it is possible for creditors to access life insurance proceeds.
One way to address these life insurance estate planning issues is the Irrevocable Life Insurance Trust (ILIT). It is important to note that because the ILIT is irrevocable, you cannot transfer the life insurance policy back to your name once it has been transferred into the trust. One major benefit of the ILIT is that you are in control. You appoint the trustees to manage the ILIT and you can determine when and how your beneficiaries will receive the policy proceeds. You can provide specifically for beneficiaries who receive government assistance without disqualifying them from eligibility.
Another benefit of the ILIT is that it lowers the value of your estate, therefore lowering the amount of estate taxes owed. An ILIT protects your policy proceeds from creditors, since the proceeds are not in your name.
In order to establish an ILIT, you must designate the trustees, your beneficiaries, and the circumstances under which your beneficiaries should receive distributions from the ILIT. Unlike regular trusts, you should not name yourself or your spouse as a trustee. If you did, the IRS could determine that the ILIT is still part of your estate and may be taxed accordingly. You can provide any manner of instructions on distributing to your beneficiaries. For instance, you may set up a monthly or annual distribution, rather than a lump sum payment. Alternately, you may allow the trustee have the discretion to determine when and how the funds will be distributed.
After you have set up the ILIT, you must acquire a life insurance policy. The owner and beneficiary of the life insurance policy will be the ILIT, not yourself personally. You can obtain an individual policy or a survivorship policy with your spouse. The trustee of the ILIT will pay the policy premiums. You will transfer cash into the ILIT each year, and the trustee will pay the premium from those trust funds.
Many individuals already have a life insurance policy and wonder if they will have to obtain a new policy to use an ILIT. You can use an existing policy. However, if you die within three years of the transfer, that policy will still be considered part of your estate. If the ILIT purchases the policy, that can circumvent this problem.
When you pass away, your beneficiaries must provide the insurance company with proof of your death. After that, the insurance company will distribute the policy proceeds to your ILIT. This avoids the probate process, saving your loved ones time and money. ILITs are a great way to address the issues a traditional life insurance policy can cause for estate planning.
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