The first step in setting up life insurance with premium financing is creating an irrevocable life insurance trust. An irrevocable life insurance trust (ILIT) sets up tax benefits to protect large estates from exorbitant estate tax obligations.
This type of trust requires several critical legal and financial decisions. To get everything right while avoiding pitfalls at the same time, it would be smart to enlist the assistance of an experienced estate lawyer and financial planner.
If you landed here, we recommend starting with our overview article Premium Financing For Life Insurance (An Easy How-To Guide).
There are a handful of trusts you can use for premium financing with life insurance. While the irrevocable life insurance trust (ILIT) is the most common, there are other options.
The main reason to use an ILIT is to entirely separate the value of your life insurance from the value of your estate. However, there are also some drawbacks. You cannot change an ILIT once you create it. You must make any adjustments in another ILIT and dissolve the first one.
But out of all your options. The ILIT is the easiest type of trust to use for premium financing. It also helps avoid premium financing risk.
How Does an Irrevocable Life Insurance Trust for Premium Financing Work?
The ILIT is a holding device for your life insurance policy. (Typically you will want an indexed universal life insurance policy for premium financing.) It removes your life insurance proceeds from the total value of your estate.
By placing your life insurance under the control of an ILIT, you provide your beneficiaries with immediate tax-free cash liquidity when you pass away. Your life insurance death benefits are immediately available to the heirs named in the trust instead of getting held up in probate.
The ILIT owns the life insurance policy and pays the premiums. You should ideally be able to arrange to have the trust pay for the premiums without having to liquidate assets. Most of the time this involves gifting the trust the interest amount on the premium financing.
Number One Reason to Use an Irrevocable Life Insurance Trust for Premium Financing
The primary reason to set the ILIT as the owner of your life insurance policy is to leverage the overall value of your estate. It entirely removes the life insurance proceeds from your estate’s total assets.
The trustee you designate for your ILIT will be the one to purchase your life insurance policy. They will also arrange for the premium financing through a third-party lender. Finally, the trustee will make the loan payments on the premium financing of a new policy, and control any existing policies you transfer to the ILIT.
How Your Irrevocable Life Insurance Trust Pays for Premium Financing
Your ILIT can pay for the premium financing through one of three different methods. Speak with our premium financing team to determine which method will be best for your situation.
- Finance a portion of the premiums
- Finance all of the premiums
- Finance the premiums plus accrued interests
The premium financing on your policy should ideally be fully repaid during your lifetime. Once the loan from the bank is paid down, the ILIT will become the full owner of the policy.
Should you pass away before paying off the premium financing loan, the death benefit proceeds from the policy repay the remaining amount. Any proceeds that remain after paying off the premium financing loan will go to the trust. The trust will distribute the money to your designated beneficiaries.
If you were to merely include the life insurance proceeds in your will, the proceeds could become entangled in lengthy probate procedures. It could also be held up by any number of potential legal, estate tax, or creditor problems.
This could then require your heirs or beneficiaries to sell off valuable estate assets to pay for these potentially expensive estate issues.
Irrevocable Life Insurance Trust Benefits
An ILIT is an enormous asset for high net worth individuals who have primarily illiquid assets such as real estate or a family-run enterprise. Setting up your premium financing for life insurance through an irrevocable life insurance trust will allow you to leverage your annual gifts.
The significant benefits of setting up an ILIT for premium financing include:
- Immediately reduces the size of your estate and thus your estate tax liability
- Potentially reduces the amount of life insurance coverage you need because it lowers your overall estate tax costs
- Protects your life insurance proceeds from creditors
- Can substantially reduce or eliminate gift tax costs related to your preferred level of life insurance protection
- Reduces your overall net cost for out of pocket expenses for life insurance
- Has minimal to no impact on your current portfolio
- Provides greater control over when and how your beneficiaries receive the life insurance proceeds
- Helps protect any government benefits if one of your beneficiaries is receiving aid for a disability
In some instances, determining how and when your beneficiaries receive the proceeds can be an important decision. We all like to think that the people we name as beneficiaries are financially responsible.
Unfortunately, this is not always the case. An irrevocable life insurance trust allows you to decide how the life insurance proceeds payout, ensuring that your heirs receive benefits at the appropriate times.
Providing for a Beneficiary on Government Aid
If your beneficiary has a disability and receives government aid, they could lose it if they receive over $2,000 a month from other sources. Social security disability counts life insurance benefits as one of those other sources.
However, you can set up the trust in a manner where they do receive funds for the following purposes without invalidating their government aid:
- Home health aide
- Medical treatments/expenses not covered under their health plan
But, if the life insurance proceeds are used for food, shelter, or clothing, then the person could lose their access to government funds.
Three Considerations When Setting Up an Irrevocable Life Insurance Trust for Premium Financing
There are three major decisions you need to make when setting up an ILIT for premium financing.
1 - Naming Your Beneficiaries
You can name anyone you choose as a beneficiary. Typically, this would be your spouse, children, grandchildren, other family members, or charities.
Ensure you identify the full name of everyone you choose. Using an identifier like spouse or children can lead to legal complications. There have been many cases where someone got divorced and remarried, or illegitimate children sue to claim proceeds.
2 - Naming Your Trustee
The trustee can be anyone you deem suitable. However, you cannot name yourself, your spouse, or any beneficiaries as your ILIT trustee.
If you do name one of the above, the IRS has the option to argue that the life insurance proceeds are not separate from the estate because they are still under your control. The Feds also may consider the proceeds as part of the estate.
Choosing your trustee with care is crucial to the success of the ILIT. They will be the individual or entity that uses the funds you send to the ILIT to pay for the premium financing to the third party lender. The trustee will be the one who distributes the life insurance proceeds according to the instructions in the ILIT.
Another function the trustee performs is filing the annual tax return of the ILIT if necessary. They will need to send out a yearly notification to your beneficiaries. This is commonly known as the Crummey Letter.
Finally, you can include a clause in the trust document allowing beneficiaries the option to vote and select new trustees.
3 - Determine How Proceeds are Payable
The final vital decision to consider when designing the requirements of your ILIT is to decide how funds will be distributed to your beneficiaries.
Payment requirements for the distribution of funds are extremely flexible. You can design them in virtually any manner that suits you. This can include:
- Proceeds distributed in full
- Proceeds can be payable in specified amounts monthly, quarterly, semi-annually, or annually for a specified period
- Can be distributed at certain milestones such as a particular age or college graduation
The trustee also has the discretion to distribute funds for a particular purpose.
Should You Buy a New Life Insurance Policy or Transfer an Existing One?
Both of these are viable options. You can also transfer an existing policy in addition to buying a new policy. Generally, it's easier to have your ILIT purchase a new policy.
However, there is a 3-year waiting period for the transfer of existing policies. The IRS requires that you must survive three years from the creation of the trust and transfer of the existing policy before they consider the life insurance proceeds separate from the estate. Until those three years have elapsed, any proceeds payable from existing policies will count toward the overall value of your estate.
There are also gift tax considerations that can apply to the transfer of existing life insurance policies.
A new life insurance policy purchased by the ILIT is not subject to the 3-year waiting period because you never legally own it.
Drawbacks of an Irrevocable Life Insurance Trust
The main drawback to an ILIT is that is it irrevocable. You cannot make any changes after it is put in place.
This includes your named beneficiaries and how many can be reallocated.
Most high net worth individuals buy permanent life insurance policies including a cash value accumulation portion. An individual owner may borrow against the cash value accumulation. However, once the ILIT is set up and a policy is transferred or purchased, you can no longer borrow against it. Neither can you access any of the premium amounts once they have been paid to the trust because you are not the owner of the policy.
How Do I Make Changes to an Irrevocable Life Insurance Trust?
You cannot make any changes to an existing ILIT. However, you do have the option of setting up a Subsequent ILIT. This more often occurs when there is a divorce or beneficiaries need to be updated.
A Subsequent ILIT is a new trust that contains the new provisions. It allows you to transfer your life insurance policies and any other assets to the newly established Subsequent ILIT. You could, for example, exclude an ex-spouse from the provisions of the new ILIT.
The current trustee can dissolve the previous existing ILIT if it holds minimal funds, and the trustee decides that the termination of the trust is reasonable in the current circumstances.
Creating a Subsequent ILIT will also entail additional expenses. You may be able to avoid this if you take the time to build in greater flexibility in the initial ILIT design.
How to Change the Trustee of an Irrevocable Life Insurance Trust
When you establish the terms of your ILIT, it’s wise to consider the possibility of needing to change the trustee at some point in the future. Talk to your estate lawyer because state laws vary on how to replace a trustee.
Most of the time terms are written into the ILIT that you can replace the trustee if all beneficiaries consent. Some states require that the grantor of the ILIT must still be living as well. Then you can determine who will be the trustee and they may accept the position.
A court motion must be drafted which includes the grounds for the replacement. Whether the motion will be approved will depend on the legal bases for replacing the trustee in your state. All beneficiaries should also sign this court motion.
It’s an involved process, but this part must be written into the ILIT. Otherwise, you cannot oust a trustee who has proven unreliable.
Gift Taxes for an Irrevocable Life Insurance Trust
Your ILIT must be set up in a specific way to avoid the potential of any gift tax liability. This is also how you maximize the estate and gift tax benefits of premium financing.
The funds transferred to the trust to pay for the annual premiums are considered gifts for federal gift tax purposes because the trustee of the ILIT owns the policy.
Currently, there is a $15,000 gift tax exclusion for individuals. Couples can double that amount with one gift from each spouse. However, this does not apply to gifts to the trust since they are considered a future interest.
However, you can draft the trust so that the beneficiaries can receive the allowable gift amounts. If the terms are drawn up so that the individual beneficiaries are notified of the gift transfer to the trust, the provisions may allow them to withdraw the money within a specific time frame. That time frame, for example, could be 30 days.
The beneficiaries would be notified in the Crummey letter of notification sent monthly by the trustee. So long as the beneficiaries do not exercise their option to withdraw the money, the trustee can then use the funds to pay the premiums.
The grantor is not subject to gift taxes so long as they do not exceed the maximum annual amount.
Conclusions on Irrevocable Life Insurance Trusts
You need a team to make this work. Make sure to talk to a tax expert to make sure you don't stumble into any of the pitfalls of premium financing. While we provide our general understanding of these topics, we cannot provide tax or legal advice.
The only way to make sure that the IRS considers your ILIT separate from your estate is to have a trustee who is not a family member or friend. You must use a professional.
Irrevocable life insurance trusts are arguably the most straightforward to use. You can fund it with gifts to each beneficiary you add. You can change the trust by created a subsequent-ILIT, so you aren't locked in. Overall, it is the best type of trust to choose for most people setting up premium financing.
How Abrams Insurance Services Can Help Set Up Your Premium Financing for Life Insurance
Our independent life insurance agency specializes in helping high net worth individuals with everything from funding buy/sell agreements with life insurance to premium financing for life insurance.
We work with over 70 of the top-rated life insurance in the company. This allows us to find a life insurance policy that fits each unique situation. For individuals or couples looking into premium financing for life insurance, we partnered with a financial management group with over 27 years experience in tailoring premium financing solutions. That way our clients have financial advice they can trust to correctly set up their irrevocable life insurance trust and premium financing.
Give us a call at 858-703-6178 to see how we can tailor a policy for premium financing to perfectly fit your estate’s needs.