Irrevocable Life Insurance Trust: Costs and Benefits
An Irrevocable Life Insurance Trust by One Pacific Trust is an increasingly specialized estate planning tool, designed to manage and control life insurance policies. In contrast to a revocable trust, once it is set up, one cannot change or terminate an Irrevocable Life Insurance Trust except with the beneficiaries' consent. This indeed makes it a strong tool in managing life insurance benefits, reducing estate taxes, and protecting assets from creditors. We will be discussing what an Irrevocable Life Insurance Trust is, how it works, the associated cost, tax implications, and the steps in setting it up.
What is an Irrevocable Life Insurance Trust?
An Irrevocable Life Insurance Trust is an entity that holds the life insurance policy outside your taxable estate. Upon the insured's death, the life insurance proceeds are paid to the trust, and the trustee distributes the benefits in accordance with the terms of the trust agreement. Because the Irrevocable Life Insurance Trust is irrevocable, once you have transferred your life insurance policy to the trust, you will be giving up all control over the policy. This allows the proceeds of the policy to be kept out of your estate for tax purposes, thereby helping minimize estate taxes and protect your beneficiaries' inheritances.
What is an Irrevocable Life Insurance Trust?
Cost of an Irrevocable Life Insurance Trust
The cost of an Irrevocable Life Insurance Trust will depend upon the complexity of your estate and the services required. In general, you may expect that the cost for creating an Irrevocable Life Insurance Trust can be between $1,000 and $5,000. The ongoing costs of trustee fees, premiums, and administration will need to be factored in.
- Legal Fees: The main cost of an Irrevocable Life Insurance Trust involves the legal fee one has to pay for the drafting of a trust document. This can be from as low as $1,000 up to $5,000, depending on the expertise of the attorney or how complex the trust is.
- Trustee Fees: Should you use a professional trustee, there may also be ongoing fees relative to their services, which could easily range between $500 to $2,000 yearly, depending on the nature and complexities of the trust involved, not to mention the level of management it needs.
- Premium Payments: As the policyholder, the Irrevocable Life Insurance Trust is liable to pay premiums to continue the life insurance policy. These are usually covered by your annual contributions to the trust.
Cost of an Irrevocable Life Insurance Trust
Irrevocable Life Insurance Trust Tax Return
Depending on the income and activity involved, an Irrevocable Life Insurance Trust could be required to file a tax return each year. Because the trust is irrevocable, it will be considered a separate entity for income tax purposes. To the extent the trust has any income, perhaps from investments, it may need to file its own income tax return using Form IRS 1041, Income Tax Return for Estates and Trusts. However, the majority of Irrevocable Life Insurance Trusts are drafted not to hold income-generating property but rather just life insurance policies, so the filings may be minimal or even inapplicable.
How Does an Irrevocable Life Insurance Trust Work?
An Irrevocable Life Insurance Trust is designed to protect life insurance proceeds from inclusion in your estate and thus avoid estate taxes. How does it work?
- Creation of the Trust: You, the grantor, create the Irrevocable Life Insurance Trust and appoint a trustee to manage the trust. The trustee can be any family member, close friend, or professional trustee.
- Life Insurance Policy Transfer: After you have established your trust, either buy a new life insurance policy within the trust or transfer one that you already own into the trust. Upon transferring the policy to the trust, the owner then is the trust, and you have no powers over it.
- Annual Contributions and Premiums Paid: You will make annual contributions to the trust to pay the insurance premiums. These contributions will be treated as gifts to the beneficiaries of the trust and may be eligible for the annual gift tax exclusion amount.
- Crummey Letters: To enable the annual gift tax exclusion, the trustee sends "Crummey letters" to the beneficiaries, advising them of their withdrawal rights with respect to the funds that have been contributed to the trust. The beneficiaries typically do nothing and do not withdraw any of the funds from the trust, but the Crummey letter permits the contribution to be a present gift for tax purposes.
- Distribution of Proceeds: The death benefit is payable to the Irrevocable Life Insurance Trust by the life insurance company upon your death. Distribution of the proceeds is by the trustee in accordance with terms of the trust agreement. Because the trust is the owner of the policy, the proceeds are not part of the estate, and hence, your beneficiaries receive them free of estate taxes.
How Does an Irrevocable Life Insurance Trust Work?
How to Set Up an Irrevocable Life Insurance Trust
The establishment of an Irrevocable Life Insurance Trust is somewhat involved. If possible, one should have it drafted by a qualified estate planning attorney to ensure it is correctly set up and strictly adhering to the letter of the law.
- Naming a Trustee: You appoint a person you trust to handle and manage your assets held inside of the trust. You can name any family member, friend, or other person as trustee, although if you want to minimize estate taxes, you cannot act as trustee. Another option is a professional trustee. The trustee shall bear some responsibilities regarding policy maintenance and keeping it in force.
- Draft the trust document: With the assistance of an attorney, draft a trust document that describes all of the terms of the trust. Name the beneficiaries and the means by which they will be given their share of the proceeds.
- Transfer the Life Insurance Policy: Once you have created the trust, you can transfer an existing life insurance policy to the trust, or purchase a new policy through the Irrevocable Life Insurance Trust. Note, however, that if you transfer an existing policy, the proceeds could still be brought into your estate if you die within three years of the date of the transfer - the "three year rule."
- Fund the Trust: You will need to make contributions to the trust on a yearly basis in an amount sufficient to pay the premiums to keep the life insurance policy in force. These contributions may qualify for the annual gift tax exclusion, if properly structured.
- Inform Beneficiaries: You should send Crummey letters to the beneficiaries of the trust every time you make a contribution to the trust. This makes the contribution a present gift and therefore it qualifies as a gift tax exclusion.
How to Set Up an Irrevocable Life Insurance Trust
Conclusion
An Irrevocable Life Insurance Trust is an important estate planning tool, which protects life insurance proceeds from estate taxes and offers financial security to your beneficiaries while ensuring that your estate plan is carried out as intended. Although it does take some up-front costs and a bit of maintenance to create an Irrevocable Life Insurance Trust, potential tax savings and asset protection could pay many times over for the investment, particularly for large estates. It is always best to consult with an experienced estate planning attorney who will ensure that your Irrevocable Life Insurance Trust is set up correctly and that it meets your financial objectives.