The Pros and Cons of an Irrevocable Life Insurance Trust
An irrevocable life insurance trust holds onto your assets to later distribute them to your loved ones or heirs.
If you have a large estate, you may be aware of the advantages of setting up an irrevocable life insurance trust.
An irrevocable life insurance trust, or ILIT, requires you to relinquish control of your life insurance policy in exchange for avoiding estate taxes.
Depending on your need for life insurance, an irrevocable trust may be essential to your estate planning. This article will discuss both the pros and cons of an irrevocable trust.
Here’s what we'll cover in this post:
Quick Article Guide
Here’s what we'll cover in this post:
Pro: Reduce Your Estate Tax Liability
When you pass away, all of your assets are calculated to determine the total value of your final estate. Your life insurance payout is included in the final number because it is considered an asset. The current federal estate tax exemption is large enough to protect most estates, but the estate tax exemption is not guaranteed.
If you purchase a large amount of life insurance, you may inadvertently create an estate tax liability with your life insurance policy. By creating an irrevocable life insurance trust, the value of your life insurance policy will be separate from the value of your estate. This strategy prevents your life insurance payout from being included in the overall value of your estate.
Note: With changes to legislation, the current estate tax exemption can be reduced or eliminated at any time. The amount of your estate that exceeds the current estate tax exemption rate is subject to a 40% estate tax.
Con: Creating an ILIT Can Be Expensive
Setting up an irrevocable life insurance trust may not be as simple as spending an afternoon on Legal-zoom. Before you start the process, make sure your estate really needs estate tax protection. Setting up an irrevocable life insurance trust can cost you a few thousand dollars and this involves appointing a trustee and meeting with an estate or trust attorney to draft a trust.
If you do not have a sizable estate, but you want to leave something behind for your loved ones, avoid an ILIT. You can save your money and eliminate the hassle of creating an irrevocable trust.
As long as you estate is worth less than the estate tax exemption for the year, your life insurance policy will still pay out to your beneficiaries as listed. In this situation you can purchase a permanent policy to leave an inheritance to your loved ones and to pay for your final expenses.
Pro: Your Heirs are Protected from Creditors
Depending on the state you live in, your life insurance payout may or may not be protected from creditors.
If you have final expenses, unforeseen medical bills, or other debts like auto loans and credit cards, creditors may be able to collect on your life insurance payout. Depending on the amount of debt you leave behind, your life insurance payout may be eliminated by your remaining debt which in turn leaves nothing behind for your loved ones.
If your life insurance is owned by an ILIT, or irrevocable life insurance trust, you do not own your life insurance policy, therefore your creditors cannot collect on an asset that you do not owe. This means they cannot try to claim a percentage of your life insurance proceeds and it ensures the entirety of your policy is paid to your heirs as you have specified.
Additionally, if your heirs are not the best at managing their finances, your trust can include a spend-thrift provision. A spend-thrift provision will pay your heirs a monthly payment instead of a large lump sum upfront. This provision prevents your loved ones from spending recklessly when they are grieving your loss.
Con: An Irrevocable Trust Cannot Be Modified
If you establish an irrevocable life insurance trust, your ability to make changes to the irrevocable trust are very limited. For instance, the IRS will not allow you to avoid estate taxes and control your life insurance policy as if it is part of your estate.
This means that once you assign your policy to an ILIT, you cannot reassign the policy to another trust or entity because you have given up all of the rights to your coverage. You can, however, change the trustee of your trust to whomever manages your trust at any time.
Typically people will name an executive of their bank, an attorney, or trusted family member as the trustee of their policy. If you select a family member as your trustee, make sure you choose someone who is financially savvy and stable. If you already have a life insurance policy for estate protection and it is not owned by an ILIT, set one up immediately.
If your life insurance is not owned by your irrevocable life insurance trust for at least 3 years prior to your passing, the IRS will not honor your ILIT. This clause is also known as an incident of ownership. The IRS will not allow someone to retain financial control over their assets/estate avoid potential estate taxes.
If you set up your irrevocable life insurance trust at the same time you buy your policy, the three year rule does not apply because in the eyes of the IRS, your ILIT has always controlled your estate.
Pro: Your Life Insurance Policy Is Private
When you pass away, your estate will become public record. This can create a problem or resentment within your family if some of your relatives are left with more assets than others. In addition, if you have outstanding debts, your creditors will be able to see the details of your final will, life insurance payout, and estate.
Losing a loved one is a difficult time for anyone. You do not want "supposed" friends or long-lost family members coming after your heirs for a share of the estate that you have left behind for them.
Transferring your life insurance policy into an irrevocable trust will allow your heirs to be able to maintain their privacy and alleviate these concerns, keeping the final details of your life insurance policy private.
Con: Setting Up An ILIT Can Be Complicated
Setting up an irrevocable life insurance trust can be a complicated process. In fact, most of our client’s get overwhelmed in the process and call us for advice. Setting up an irrevocable trust is not a simple “do-it-yourself” project that can be completed in a weekend.
If you’re not sure where to begin, or if you want to know if an irrevocable life insurance trust is right for you, we can help. If you’re not ready to speak with an agent, please feel free to use our free estate planning calculator to determine your need for coverage.Our agents are experts at estate planning and offer at least a decade of experience in the life insurance industry. We can help you get the process started and provide you with the most aggressively-priced life Insurance options available.
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Managing Partner and Co-founder
Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.