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September 29, 2022 at 09:33 PM
What You Need to Know
- Buying the policy at the wrong time is bad.
- So is leaving out Crummey withdrawal rights.
- Ignoring administrative expenses? Just no.
Life insurance is often a cornerstone of a comprehensive estate plan, particularly when an estate consists of largely illiquid assets.
Irrevocable life insurance trusts (ILITs) are a common planning tool used to maximize the benefits of life insurance when it is being purchased to provide liquidity to pay estate tax.
Although ILITs have been around for decades, there are a number of pitfalls that can undermine their effectiveness.
By being aware of some of the more common snares, advisors can help their clients (who, more often than not, rely on their advisors to navigate sophisticated planning) to avoid these traps.
Outlined below are three of the common problems that arise in connection with funding and administering ILITS.
Pitfall 1: Purchasing a New Policy Outside of the ILIT
If an individual purchasing a new life insurance policy buys the policy and then transfers it to an ILIT, the death benefit will be included in the insured’s estate for estate tax purposes if they die within three years of the transfer.
This is because Internal Revenue Code Section 2035 causes estate tax inclusion for an individual who transfers or otherwise gives up power over a life insurance policy within three years of death.
However, if an individual who plans to create an ILIT instead establishes and funds the ILIT first so that ILIT can purchase the policy directly, the death benefit will be excluded from the insured’s estate regardless of how long they survive the purchase date.
Thus, to avoid this pitfall, advisors should determine at the outset whether their clients plan to create ILITs so that purchase of the policy can be appropriately sequenced.
Pitfall 2: Failing to Abide by the Crummey Protocols
Unless or until the premiums on a life insurance policy are fully paid or otherwise self-sustaining through a draw on the cash surrender value, the insured must make gifts to the ILIT to cover the premiums.
Oftentimes, clients wish to use their annual gift tax exclusion to make such contributions.
To qualify the gifts for the annual gift tax exclusion, the beneficiaries of the ILIT must have the right to withdraw certain amounts that are transferred into the ILIT.
Failure to include the requisite withdrawal rights may eliminate the ability to offset gifts by the annual exclusion amount.
Even if an ILIT includes so-called Crummey withdrawal rights, a client also will not be able to take advantage of the annual gift tax exclusion if the beneficiaries are not informed of their withdrawal rights each time an eligible contribution is made to the ILIT.
