Life insurance can help meet a number of estate planning goals, including replacing income needed to support a surviving spouse and children, providing liquidity to pay estate taxes and other liabilities when cash is tight, and helping you save and invest in a tax-efficient manner.
But the best-written and administered life insurance policy is only a part of a good plan. If you stopped there, you’d have gone a long way toward meeting the above goals, but in many cases, you would have missed out on an opportunity to ensure that the policy proceeds go towards the uses you intended and are not lost to unnecessary estate taxes or misuse.
An important next step in estate planning with insurance is to consider whether you should have an irrevocable life insurance trust (an “ILIT”) to purchase and hold the policy and distribute the proceeds. The primary advantages to using an ILIT include potential estate tax savings and ensuring that the proceeds are used for the purposes for which the insured person intended. I will discuss each benefit below.
Estate Tax Savings
Estate and gift taxes are imposed by the federal government and many states on the transfer of wealth. In many cases, a person’s largest transfer of wealth occurs at the end of life, when any remaining property is left to his or her heirs. If the amount remaining is large enough, the state and federal governments may take a piece of it through their estate taxes.
Under laws in effect in 2014, each person in Connecticut can pass up to $2 million to heirs without being subject to state estate tax. New York has a similar exemption of $2,062,500 in 2014, and that is set to increase over the next several years and eventually match the federal estate tax exemption, which is $5.34 million in 2014.
An estate that is valued below both the state exemption and the federal exemption will not be subject to estate taxes. If the value of an estate is over the state exemption, but not the federal exemption, that estate would be subject to state estate tax only. In Connecticut, the estate tax rates range from 7.2% to 12% of the amount over the $2 million exemption amount. For example, if you left an estate of $3 million, Connecticut’s tax would be 7.2% of $1 million, for a tax bill of $72,000.
Estate tax bills can skyrocket if the estate is over both the state and federal exemption amounts. For example, a Connecticut estate of $10 million would owe over $700,000 in Connecticut estate tax and over $1.5 million in federal estate tax. Although the total tax bill in this example is about 22% of the estate because of the large exemption amounts, it’s very important to keep in mind the marginal tax rate, meaning the rate of tax imposed on each additional dollar. For an estate of $10 million, the combined Connecticut and federal marginal tax rate is upwards of 45%. In other words, if you had assets worth $10 million, and you purchased a life insurance policy without engaging in proper planning, almost half of that policy could be lost to estate taxes when it eventually pays out. But that tax loss could easily have been avoided.
An ILIT is useful for estate tax planning because a properly structured and administered ILIT can protect life insurance proceeds from estate tax, regardless of the size of the person’s estate or the size of the policy. An ILIT can avoid estate taxes because it is not viewed as part of the donor’s estate, as long as the donor has given the ownership and control over the policy to another person as trustee.
If your estate is already over the applicable state and/or federal estate tax exemption amount and you are considering purchasing a new life insurance policy, we recommend that you consult with an estate planning attorney to see if an ILIT would be right for you. Because it is important for tax reasons that the policy is issued in the name of the ILIT, we recommend consulting an attorney before you submit an application to the insurance company.
Another important use for an ILIT is to help ensure that the policy proceeds are used as the donor intends. The ILIT trust agreement can stipulate limitations and conditions on the use of the proceeds by the trust beneficiaries. For example, the donor might choose to provide that no distributions can be made to a beneficiary under a certain age so that beneficiaries are mature enough to handle wealth before they receive large distributions from the trust.
An ILIT can also help protect the insurance policy proceeds from creditors of the beneficiaries. For example, the donor’s daughter could be involved in a risky business venture and subject to personal liability if anything goes wrong. Or, maybe the donor’s surviving spouse will marry someone else after the donor’s death, possibly exposing the donor’s assets to claims by that other person. An ILIT can include terms to make sure that a beneficiary’s potential creditors cannot divert assets away from the donor’s intended beneficiaries. This assurance would not be possible with a life insurance policy alone.
Since these types of creditor issues are inherently unpredictable, the asset protection benefits of an ILIT can be very important to anyone, regardless of current family circumstances. If you would like to know more about how an ILIT can help ensure that your life insurance proceeds are available for your intended beneficiaries for the long-term, please consult an estate planning attorney.
To this point, we’ve sung the praises of ILITs. But they are not right for everyone. Sometimes the costs of an ILIT outweigh the benefits. One disadvantage of using an ILIT is that it requires a greater expense of time and money relative to simply purchasing an insurance policy. ILITs are complicated and need to be carefully drafted to qualify for estate tax benefits. Someone who is concerned about health issues or who otherwise needs to move quickly to put a policy in place may not have time to work out the terms of an ILIT beforehand. Even if time is not a factor, the size of the policy may not warrant the financial costs of setting up and administering an ILIT.
Another disadvantage is that an ILIT is irrevocable and inflexible (it must be in order to achieve the estate tax benefits). While it is relatively easy to change the beneficiary designation on a life insurance policy if the insured changes his or her mind about who should benefit from the policy, it may be very difficult or impossible to alter the terms of an ILIT. This inflexibility can be managed somewhat by giving the trustee of the ILIT broad discretion regarding the timing and amount of distributions, but an ILIT simply will never be as flexible as holding the life insurance policy outright.
We’re Here to Help
In light of these considerations, it is difficult to decide whether to use an ILIT. And once the decision to use an ILIT is made, it takes considerable legal expertise to decide on the proper terms for the ILIT and to draft a trust agreement and related documents.
At Mead, Bromley & Bishop, our lawyers have decades of experience in helping clients make the right estate planning decisions to achieve their goals, and we would be happy to help you think about, and implement, an ILIT if that is the best way to advance your goals. If you would like our assistance setting up an ILIT or reviewing an existing one, please contact us by calling 203-325-4477 or by using the contact form on our website.