Over the next week or two, I'm going to be talking in some depth about irrevocable life insurance trusts (often referred to as ILITs by estate planners). Today I'd like to talk generally about these types of trusts.
There are many reasons to set up revocable trusts, such as living trusts: avoidance of probate, privacy, and controlling when your beneficiaries receive their inheritance are just three. By contrast, most people set up irrevocable trusts, such as ILITs, for only one reason: to pass property to beneficiaries at your death free of estate tax. This works because an irrevocable trust is, well, irrevocable. And that irrevocability goes not only to the trust document you sign, but to any property you contribute to the trust. You no longer own it, which means you can't get it back or control it in any way. This is why property held in a correctly-drafted irrevocable trust will not be subject to estate tax when you die -- because it's no longer your property.
How does a typical ILIT work? Here's an example:
1. Grantor (Mr. Grant), a 47-year-old, signs an ILIT with his sister (Ms. Trust) as trustee.
2. The trust provisions are for the benefit of Mr. Grant's three children, and are similar to the provisions in Mr. Grant's living trust.
3. Mr. Grant contributes $15,000 per year to the trust.
4. Ms. Trust uses the yearly contributions to buy a life insurance policy on Mr. Grant, with the trust as beneficiary. (I'll talk about types of life insurance at a later time, but let's assume $15,000 per year would be enough to pay the premiums on a $1 million whole life, or "permanent," policy.)
5. Mr. Grant dies, and the insurer pays $1 million to his beneficiary (the trust). Mr. Grant has passed $1 million to his three children free of estate tax and income tax.
There's obviously a leverage aspect at work here. If Mr. Grant dies in three years, he's paid $45,000 (in premiums) to "get" $1 million (to his kids as an inheritance). Of course, if Mr. Grant dies in 40 years, he's paid $600,000 to get $1 million -- not the best return.
Next time I'll talk about ILITs and gift tax.
