In lay terms, an irrevocable life insurance trust is a way to create an estate that you may pass on to beneficiaries unaffected by income and estate tax regulations. After creation, it cannot be revoked or altered by the settlor (the one who creates the trust). The first example shows how the estate tax would work in the absence of an irrevocable life insurance trust. The second example shows how that is modified by using an irrevocable life insurance trust.

In our first example, John is single with two children, and has an estate consisting of community property that includes a $600,000 business, a $500,000 house, a retirement plan worth $800,000, stocks and bonds worth $100,000, and an insurance policy worth $1,000,000. John is killed in a car accident, and is survived by both children. His estate is worth $3,000,000. In 2008, the children will receive $2,000,000 tax free. The remaining $1,000,000 will be taxed at 45% percent, so the children will receive $550,000, for a total of $2,550,000.

Now lets take a look at the benefits of an irrevocable life insurance trust. Consider the facts given above, except this time John creates an irrevocable trust and places the life insurance policy into it. If certain requirements are met, then the life insurance policy is removed from his taxable estate. In 2008, John can make a yearly tax free gift on behalf of each child of $12,000 for a total of $24,000 to fund the policy, though he might not need to contribute that much. John’s children will receive the $2,000,000 estate and the entire value of the $1,000,000 life insurance policy tax free, provided John does not die within 3 years of creating the trust. If John dies during that time, then the life insurance policy will be considered part of his estate. If the purchase of the policy is made by the trustee instead of John, this 3 year period is avoided.

Considering the disposition of the trust insurance policy alone, John now has several advantages. The first advantage is John’s ability to structure the trust. For example, John may believe his children are immature and will spend the money irresponsibly. He can structure the trust so that his children do not receive all the money at once, but upon monthly installments. If the beneficiary is his elderly spouse, John may be able to structure it so that it protects the benefits of the trust from reducing government assistance.

Another difference between a living trust and an irrevocable trust is control over the trustee, the distribution, and beneficiaries. To show the IRS that the trust is irrevocable, certain conditions must be strictly complied with. The settlor of the trust cannot be a trustee or beneficiary. In other words, John cannot name himself as trustee or beneficiary or the IRS will consider it a revocable trust. Likewise, if John names his spouse or domestic partner as a beneficiary then that person cannot be a trustee. The role of trustee, and successor trustees, can be filled by anyone that is independent of the trust, but typically a reliable family member, financial institution, or professional adviser performs the role of trustee.

Upon death, the trustee will distribute the funds according to the terms dictated by the settlor. The trustee will also be responsible for filing the annual tax return for the trust, and sending out the annual “Crummey” letter [based upon the name of the person who established the right in a famous case]. In order for your annual payment to qualify as a tax free contribution to the trust it must be a present interest - it must be immediately available to the beneficiaries. This means that a letter must be sent to the beneficiaries notifying them of the deposit to the trust, and for 30 days your beneficiaries will have the right to draw upon the money. If after 30 days they do not do so, the trustee may apply the funds to the life insurance policy. Obviously, it is important to have the collaboration of the beneficiaries so that the money is not taken from the fund.

ADVANTAGES

Transferring Wealth Outside of Your Estate

• The irrevocable life insurance trust can operate in combination with other advanced estate planning tools to remove wealth from your estate thereby reducing taxes and increasing the amount available to your beneficiaries. Once you have provided for your heirs, you may then use other estate planning tools to further reduce tax liability.

Avoiding Probate

• The irrevocable life insurance trust avoids the cost, delay, and publicity of probate.

Avoiding Creditors

• The trust may not be available to the creditors of the beneficiaries.

DISADVANTAGES

 

Loss of Control Over the Trust

 

• Although the settlor has quite a lot of control over the disposition of the assets when establishing the trust, there is still a loss of control once the trust is formed. For the most part, however, life insurance is uniquely suited to placement in an irrevocable trust, and most problems can be avoided by carefully wording the terms of the trust.

Loss of Access to the Cash Value

 

• Once a life insurance policy is placed in an irrevocable trust, the cash value of the policy cannot be accessed.

You Must Qualify for Life Insurance

 

• Some individuals may not qualify for life insurance because of health conditions or infirmity. In these cases, the premiums may be too expensive for the benefits received.