How Does an Irrevocable Life Insurance Trust Work?
Life insurance frequently serves as a key component of thorough estate planning, especially when assets are largely difficult to convert to cash quickly.
Irrevocable Life Insurance Trusts (ILITs) represent a widely-used planning mechanism designed to help ensure life insurance policy benefits can sidestep estate taxes and align with the policyholder’s wishes. However, common errors – such as purchasing policies at the wrong time, omitting Crummey withdrawal rights, and neglecting administrative costs – can undermine an ILIT’s effectiveness.
Three Critical Mistakes to Avoid
Policy Purchase Timing
A frequent error involves buying a new life insurance policy and subsequently transferring it to an ILIT. If death occurs within three years of the transfer, the death benefit becomes part of your taxable estate, eliminating intended tax advantages. Under IRS Section 2035, any transfer or relinquishment of life insurance control within three years of death triggers estate tax inclusion.
The solution is straightforward: have the ILIT itself purchase the policy directly. This approach excludes the death benefit from your estate regardless of longevity following the purchase.
Crummey Withdrawal Rights
Unless premiums are fully paid or self-sustaining through cash surrender value draws, the insured must gift money to the ILIT for premium payments. Many people prefer using their annual gift tax exclusion for these contributions. However, to qualify gifts for this exclusion, ILIT beneficiaries must possess withdrawal rights on transferred amounts.
Failing to include these withdrawal rights eliminates annual exclusion benefits. Additionally, beneficiaries must receive notice of their withdrawal rights each time an eligible contribution occurs. Consult your estate planning attorney regarding proper procedures and documentation before signing.
Administrative Cost Funding
ILITs typically hold limited assets – primarily the insurance policy and premium payment amounts. If administrative expenses arise (accounting, legal, or trustee fees), insufficient funds may exist to cover them.
Paying expenses directly constitutes a taxable gift, as you’re deemed to have first transferred funds to the ILIT. Instead, fund your ILIT with sufficient money for both premiums and administrative costs. With a broad beneficiary class holding Crummey withdrawal rights, this funding can occur entirely through annual exclusion gifts.
If you or a loved one needs assistance with life insurance trusts or estate planning, do not hesitate to contact The Stegall Law Firm for a consultation.
