It is no surprise that life insurance is one of the most commonly purchased financial products in the U.S. The benefits of life insurance can provide critical financial relief in the wake of the death of a loved one. Life insurance proceeds can replace the earnings of a breadwinner or cover cost of burial and unpaid taxes. With all of the benefits that come with life insurance, it is also important to be mindful of some of the potential pitfalls associated with life insurance. There are potential tax consequences to consider as well as the problems that can come from beneficiaries receiving large, lump sum cash payouts. One way to avoid these potential pitfalls is through the creation of an irrevocable life insurance trust.
What is an Irrevocable Life Insurance Trust?
An Irrevocable Life Insurance Trust (ILIT) is an estate planning tool where you transfer ownership of your life insurance policy to that of an irrevocable trust. Irrevocable means that, once created, you will be unable to take the policy back into your own name. You are, however, able to establish the trust in the way that you provide who will benefit from the trust. You also have the opportunity to define the terms of when the beneficiaries may receive benefits from the trust. Additionally, you may choose a trustee and successor trustee to manage the trust.
Because you transfer ownership of your life insurance to the ILIT, your life insurance proceeds will not pass through probate as part of your estate. This means that it will avoid the costs and time consuming process of probate. Depending on the terms of the trust, your beneficiaries may have more immediate access to trust proceeds than they would should they have to wait for probate to wrap up. An additional benefit of an ILIT falling outside of your estate is that the proceeds of your life insurance will not be included in calculating the value of your estate. This means that you avoid what can be a significant impact on estate tax liability.
As stated above, you have the power to establish the terms of the trust. This means you choose the beneficiaries. It also means you choose how and when those beneficiaries receive distributions from the trust. Receiving a lump sum payout of life insurance proceeds can be problematic for multiple reasons. For instance, those who struggle with managing finances are likely to be overwhelmed with a sudden financial windfall. This will, inevitably, lead to waste and quickly blowing through what you have left them.
Additionally, you can structure the ILIT in a way that will not jeopardize a beneficiary’s continued receipt of government aid. Many government programs are need-based. It may have been well-intentioned to leave money to a loved one, but, if they are receiving government aid, they may lose critical benefits because of the inheritance. Through properly employing an irrevocable trust to hold the proceeds of your life insurance, you may shield your beneficiary from this consequence. Properly structured irrevocable trusts will avoid inclusion of trust assets in income and resource calculations for government benefit purposes.
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