The good old life insurance policy can be used as a more functional estate planning tool for those trying to pass more wealth to their heirs than to Uncle Sam. By forming an Irrevocable Life Insurance Trust, you can pass on wealth without taking a big tax hit.
"The key is you have to have an estate for tax purposes that is in excess of $3 million between spouses," says John Blatt, a certified family business specialist for Skylight Financial Group.
With a $1.5 million per-person tax exemption, an ILIT only makes sense for those with more than $3 million.
"If you spent 30 or 40 years with an employer, you might retire with accounts worth a million or two, and when you add in things like homes and life insurance, it's not that hard to be worth more than $3 million," says Blatt.
An insurance policy set up as part of an ILIT is not considered part of the estate. The trust is the owner and beneficiary of the policy, with the person you want to receive the money named as the beneficiary of the trust.
"Usually the size of the policy is tied to what the grantor wants to accomplish," says Blatt. "If, say, your estate might owe $5 million in taxes, the idea is to buy a $5 million policy and put it in an ILIT, so when the person dies, it would pay that. This is especially important if your money is not liquid, such as if a lot of your wealth is tied up in a family business, for instance.
"If you didn't have the insurance, your heirs would have to go borrow money to pay the tax."
Existing life insurance policies can be transferred to the ILIT, but the owner must survive for three years after the transfer before the proceeds become exempt from estate taxes.
Once established, you will also have to provide cash to the ILIT to pay for the insurance premiums. How much you can provide depends on several factors, but it basically ranges from $5,000 to $11,000 per beneficiary per year.
So if you have a large insurance policy requiring a premium of tens of thousands of dollars a year, you may have to name multiple beneficiaries to be able to gift enough money to the trust to pay for the policy.
Beneficiaries of the trust do have withdrawal rights for a limited time when cash is transferred, so be careful who you name. Otherwise, your rowdy middle child may see the trust as a great way to fund his professional skateboarding career.
ILIT's can be a great way to either avoid estate taxes or help pay them.
"Life insurance is purchased by people who either owe someone or love someone," says Blatt. "But you have to have the right situation for it to apply." How to reach: Skylight Financial, (216) 592-7313