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How To Protect Your Family’s Financial Security

One of the main reasons we buy life insurance is so that when we pass, our loved ones will have enough money to pay off our remaining debts and final expenses. We also purchase life insurance to provide for our loved ones’ future living expenses. Proper planning can help protect your family’s financial security.

The Key is Ownership. Generally, all the property you own at death is subject to federal estate tax. Estate tax is imposed only on property in which you have an ownership interest; so if you don’t own your life insurance, the proceeds will generally avoid this tax. For many, the answer is to have an irrevocable life insurance trust, or ILIT (pronounced “eye-lit”).

What is an ILIT? An ILIT is a trust primarily set up to hold one or more life insurance policies. The main purpose is to avoid federal estate tax. The policy is a separate entity that you don’t own, the trust owns it. You name the ILIT as the beneficiary of your life insurance policy and your family is the beneficiary of the ILIT. Therefore, your proceeds will not be subject to an estate. If the trust is drafted and funded properly, your loved ones should receive all of your life insurance proceeds. Be aware that it is irrevocable once you sign the trust agreement, so you can’t change your mind or end the trust.

Creating an ILIT You should hire an experienced attorney to draft and execute an ILIT agreement. You will have to pay an attorney fee but the potential estate tax savings should more than cover this cost.

An ILIT can be funded two ways:

  1. Transfer an existing policy. There is a 3-year waiting period so you need consider your own age and health.
  2. Buy a new policy. To avoid the three-year rule, the trust pays the annual premiums. You may transfer the funds to the trust to cover the premium.

Gift Tax Consequences Cash transfers you make to the trust are considered taxable gifts. However, if the trust is created and administered appropriately, transfers of $13,000 or less per trust beneficiary will be free from federal gift tax under the annual gift tax exclusion. The annual gift tax may change in future years.

Crummey Withdrawal Rights All beneficiaries must be given written notice of their rights to withdraw whenever you transfer funds to your ILIT, and they must be given reasonable time to exercise their rights (30 to 60 days). It’s the duty of the trustee (FSB) to provide notice to each beneficiary. As not to defeat the purpose of the trust, the beneficiaries should not actually exercise their Crummey withdrawal rights, but should let their rights lapse.