The answer to “Why an ILIT?” If you have a taxable estate, then an Irrevocable Life Insurance Trust creates free money. Really.

OK, so your estate is going to be taxable. You get it. Your family will be paying out a chunk. In order to be prepared for that reality, you can choose to keep that chunk in cash or near cash assets – which we all know gives pretty poor returns AND isn’t always possible to do. Just to be realisitic, you may have mortgages or lines of credit that will be called due at death.

Read your promissory note sometime; death is usually a basis for the lender to demand full payment. Or they could just “deem themselves insecure.” Had a bad day? Feel a little insecure? Call in some loans!!

Wouldn’t it be nice if you could buy that money at the very time it is needed at a discount? You are right, that is life insurance. Pay a little each year over your lifetime and a lot is paid out where you want it at your death. Sorry, not a lot of fun for you, but boy, it will care for the people you care for! Great. Buy life insurance and it increases your estate tax! About one-third to one half of the added insurance will go to taxes – – – unless you create an Irrevocable Life Insurance Trust to buy and own the insurance. If you do that, the money needed will be there without estate tax. The amount saved is truly free!

How does it work? You – called the “Settlor” or “Grantor” – create a special type of trust called an Irrevocable Life Insurance Trust, or ILIT for short. It may be just labeled as an Irrevocable Trust, but have extra language that facilitates the ownership, management and use of the life insurance death benefit to coordinate with your estate. If so, it is an ILIT, a carefully designed trust for a very specific purpose. In the ILIT you name someone other than yourself as Trustee. Usually the Trustee is a professional or institutional trustee, because it is important enough to use professionals, a little complex, and a bit of a burden to family and friends. The professionals will cost something, probably $2,000 to $5,000 annually, depending on a number of factors.

You as the Settlor make a contribution to the trust. In the Trust, you have named certain persons to be “present interest” beneficiaries, with a right to receive a pro-rata share of any contribution. They are entitled to receive notice of the contribution, and may exercise their withdrawal right for up to thirty days following receipt of the notice. Currently the annual gift exemption is $13,000 per donor, and per donee. Married persons may join with each other to make gifts. So if there are three “present interest” beneficiaries named in the trust, and spouses join together to make the contribution to the Trust, the maximum amount which can be treated as annual exempt gifts is:

The Trustee says: “Settlor, I have the money you contributed, and the notices to the present interest beneficiaries have come back with all of them waiving their withdrawal rights. I would like to buy life insurance on your life, and have arranged with this fine representative to do that.” The life insurance is owned by the trustee on behalf of the Trust, and is NOT part of your estate. If you transfer existing life insurance to an ILIT, the Internal Revenue Code treats it as taxable in your estate if you die in three years or less.

Now what? You continue to make contributions to the Trust. Contributing more than is needed for the insurance premium is wise, and the Trustee will invest it, probably in cash accounts until there is enough to do something else. Variable Life Insurance would allow most of the extra contribution to be invested within the life insurance, into the various investment funds available.

The best part is there is more “FREE MONEY.” Investment yield “inside” a life insurance policy is not income taxable until a policy is surrendered. That’s right, not even at death! The proceeds of the death benefit are both income and estate tax free in the ILIT. The ILIT is both authorized and directed to use the proceeds to loan to your estate, or buy assets from it. Your estate (or living trust) then has the cash it needs to pay loans and estate taxes. The assets now held by the ILIT are used for the benefit of your beneficiaries – and note – the “present interest” beneficiaries may not all be the ultimate beneficiaries!

ILITs are therefore “free money,” and one of our favorite tools to preserve families and their assets.