Irrevocable Living Trust

Generally, when people talk about living trusts, they refer to revocable living trusts. A revocable trust is a trust document where the person creating the trust retains control of the trust property. The person creating the trust (the grantor or settlor) frequently serves as the trustee.

With revocable trusts, the grantor can change the terms of the trust and move trust assets any time before the grantor's death. In contrast, irrevocable living trusts can't be terminated. The grantor gives up complete control over the trust property. The grantor creates the trust during their lifetime but cannot change or amend it.

So, why would you want to give up complete control of your property to an irrevocable living trust? For various reasons, irrevocable living trusts can be a good option, including for tax purposes.

Irrevocable living trusts have tax advantages that revocable trusts don't provide. Irrevocable trusts also shield assets from creditors. They can help provide for family members who would benefit from trust funds. These family members may not be able to be trusted with receiving a single large gift.

Understanding Irrevocable Living Trusts

Creating an irrevocable trust is a serious decision. You'll give up control over the trust property with an irrevocable living trust, but you determine the uses of the trust assets. You also select who serves as the trustee and the successor trustee.

The trustee takes legal ownership of the trust assets. The trustee also assumes fiduciary responsibility for managing those assets and carrying out the purposes of the trust. The trustee owes fiduciary duties to the trust beneficiaries. You determine the eligibility for trust beneficiaries. This includes choosing the identity of the beneficiaries. You can even retain the right to change them.

The key features of irrevocable trusts are reflected below:

• No modifications: The trust can't be changed or modified once you create it.
• Personal tax benefits: You can transfer appreciated assets, such as stock and real estate, into the trust. When this occurs, the grantor will save on capital gains taxes. The trust is its own entity with its own tax ID number. It shifts income tax away from you and to the trust. The trust has its own tax return. An irrevocable trust doesn't avoid taxes entirely, though.
• Property ownership: Once you place property into an irrevocable trust, it no longer belongs to you. This can simplify the probate process for your loved ones. Owning fewer probate assets can reduce the time and expense involved in the probate process.
• Asset protection: Property in a trust is generally shielded from outside creditors, liens, and divorcing spouses.
• Long-term care: Moving assets to an irrevocable trust allows the grantor to obtain Medicaid benefits if they go into a nursing home. By placing assets into an irrevocable trust at least five years ahead of the actual need, the grantor has secured their assets to the benefit of named beneficiaries.
• Trustees: Unlike a revocable trust, the grantor cannot serve as the trustee of an irrevocable trust.
• Estate tax savings: The grantor no longer owns the property. It's not included in tax calculations of the total value of the estate's assets at the time of death. Thus, it reduces the value of your taxable estate. This could be the difference between getting a hefty tax bill from the IRS (if the estate exceeds the federal estate tax exemption) and avoiding estate taxes altogether.

A testamentary trust is set up after a grantor's death by including the trust in their last will and testament. On the other hand, a grantor creates an irrevocable living trust during their lifetime.

Types of Irrevocable Living Trusts

There are many reasons to create an irrevocable living trust. This ranges from the long-term care of a disabled beneficiary to shielding a home from estate taxes. A few of the more common irrevocable trusts are described below.

Bypass Trust

A bypass trust is also known as a family trust or an AB trust. It helps a family save on estate taxes. You can also use a bypass trust to provide income to your spouse or other family members during the surviving spouse's lifetime.

You and your spouse will each have provisions in your wills directing personal assets, not community property, to be used to fund the trust. An example of an asset used to fund these trusts includes assets already in a revocable living trust. Another example is the proceeds of a life insurance policy or retirement account that names the bypass trust as beneficiary.

Irrevocable Life Insurance Trust

An irrevocable life insurance trust owns a life insurance policy during the insured's life. The trust distributes the life insurance proceeds after the grantor's death. This is one of the most frequently used estate planning tools because of the tax savings benefit. The tax rules are complicated. By excluding the life insurance assets from the insured's estate, this trust can more than double the policy proceeds payable to heirs.

You can find more information about this trust further down in this article.

Special Needs Trust

Typically, people with disabilities qualify for government assistance. Such programs include Supplemental Security Income (SSI), Medicaid, vocational rehabilitation, and subsidized housing. If these beneficiaries received an outright gift, it could jeopardize their government benefits. Income from a special needs trust can pay for housing, assisted living arrangements, education, training, vacations, professional services, and hobbies.

Qualified Person Residence Trust

Also known as a QPRT, the grantor transfers the title of their home to the trustee of the trust. However, the grantor keeps the right to live in the home rent-free for a number of years called for by the trust. The grantor pays all the ordinary expenses. At the end of the term, if the grantor is still living, the residence passes to the beneficiaries, usually the grantor's children.

Spendthrift Trust

This estate planning tool seeks to protect a beneficiary from wasteful spending. Such spending may otherwise rapidly exhaust the trust assets. The assets are generally creditor judgments or any attempts to attach or lien against the beneficiary's trust interest.

Charitable Remainder Trust

With a charitable remainder trust, a grantor can transfer assets to their beneficiary and then disperse the remaining trust assets to a charity. The grantor may be able to take a partial income tax deduction for funding the trust.

A charitable remainder trust provides distributions to at least one non-charitable income recipient for a set number of years. The remainder goes to at least one charitable beneficiary. It allows you to donate generously while receiving tax benefits.

The Irrevocable Life Insurance Trust: An In-Depth Look

Life insurance is among the most common financial products in America. It provides consumers with an invaluable and cost-effective source of funds for loved ones after death.

Life insurance proceeds can help:

• Replace a breadwinner's earnings
• Fund an important family goal (such as a college education)
• Cover burial costs or unpaid taxes

Receiving insurance benefits after an insured person's death can offer a much-needed financial lifeline. Insurance proceeds can ensure your loved ones can maintain their standard of living. This is a good thing.

But when an estate's value is close to the federal estate tax exemption amount, life insurance proceeds can push the estate's value over the limit. When this occurs, the tax law will impose liability on the estate.

Enter the Irrevocable Life Insurance Trust (ILIT). Like most trusts, an ILIT is a holding device. For example, you can fund a revocable trust with real estate. A revocable trust can be changed or revoked by its creator or “grantor." Such a trust would own your real estate to benefit the beneficiaries of the trust.

An ILIT owns your life insurance policy. That means the policy will no longer be a part of your taxable estate. As its name suggests, an ILIT is an irrevocable trust. Once the grantor has created the trust document and named the trust as the life insurance policy beneficiary, the policy cannot be withdrawn.

ILITs and Estate Tax

The value of the taxable estate for estate tax purposes includes everything owned in your name at the time of death. That includes the death benefit proceeds of life insurance policies over a certain dollar amount. Insurance benefits can push the gross estate value beyond the taxable threshold for large estates. This can cause an estate tax liability.

An ILIT keeps the life insurance proceeds out of your taxable estate. Insurance policies that fund an ILIT are trust assets. The trust, not your estate, owns the insurance policies. Thus, the estate tax liability doesn't increase.

ILITs and Estate Planning

An essential part of wise estate planning is deciding on your heirs. An estate plan also considers how and when the heirs will receive an inheritance. Life insurance provides an immediate and often considerable payout of cash to beneficiaries. Even financially responsible adults may find a sudden windfall of money from a life insurance policy overwhelming.

The trust creator defines how the trust will operate. You can name beneficiaries and determine how they will receive the life insurance payout.

• If liquidity is needed to give heirs access to funds right away, a one-time lump sum payment is the best option.
• If beneficiaries of the trust are minors, their guardian may prefer a series of payments.
• You can choose the trustee (or trustees) to manage your ILIT. The trustee cannot be you. Here's why: In some states, creditors can seize the cash value of a life insurance policy to settle a claim against the estate. An ILIT provides asset protection. As an irrevocable trust, the donor cannot access the assets in the trust. The trust assets are out of their control. But if you were a trustee, you would have some degree of control or "incidents of ownership." The trust would then lose its ability to protect assets from creditors.
• If your loved ones have poor money management skills, choose a trustee with wealth management experience.

ILIT Beneficiary's Access to Government Benefits

If a beneficiary of an ILIT receives benefits under a government program, such as Social Security or Medicaid, the proceeds from your life insurance policy could make them ineligible for further benefits. Your beneficiary will only regain eligibility for government aid once all the money from your life insurance has been spent, usually on basic needs.

An ILIT can protect access to government programs. At the same time, your insurance proceeds can fund things like:

• Education
• A home health aide
• Medical treatment not covered by Medicaid

The trustee will retain ownership of the life insurance policy's proceeds to ensure access to government benefits. The trustee will manage how the money is spent. The beneficiary will not own the proceeds outright.

How Do I Set Up an ILIT?

To start the process, you'll work with an estate planning attorney to design your ILIT. A financial advisor can also help you with tax planning and choosing the right amount of life insurance. Your estate planning attorney will help you establish and fund the trust. Next, you will:

1. Name Your Beneficiaries

The choice is completely up to you, although most people name their children, grandchildren, or other close family members.

2. Name Your Trustees

Different types of trusts have different rules. Living trusts allow the grantor, the grantor's spouse, or both to serve as trustees. That's not the case with an ILIT. If you or your spouse are insured by the life insurance policy owned by the ILIT, and you also serve as a trustee, the IRS may decide that the policy hasn't left your estate after all. That could impact your estate tax liability.

The trustee you name will manage the trust following the directions outlined in the trust documents. Once you've passed away, that person will oversee the distribution of the policy's proceeds. The trustee must distribute the assets according to the trust directives.

3. Determine the Conditions Under Which Your Beneficiaries Will Receive Money

Those conditions are really up to you. The policy's proceeds can be paid out immediately to one or all of your heirs. Or they could receive monthly or annual distributions. You could dictate that beneficiaries receive money when they attain certain milestones. Typical life moments include graduating from college or getting married. Your trustee can be flexible and provide distributions when your beneficiary needs it most.

4. Acquire a Life Insurance Policy

The next step is to acquire a life insurance policy. You'll go about this process as you would normally, except that the owner and beneficiary of your policy will be your ILIT. Also, you won't pay the insurance premiums directly. The trustee will pay premiums to the insurance company.

You can use an individual life policy, or if you and your spouse are both living, you can use a second-to-die ("survivorship") policy. This kind of policy only pays out a death benefit after both spouses have passed away.

You can also use an existing insurance policy. But if you die within three years of transferring the policy into the ILIT, the IRS will include the policy in your estate for estate tax purposes. Also, there are gift-tax considerations if an existing policy is used for an ILIT.

Despite these issues, from a financial planning perspective, transferring an existing policy from your estate into an ILIT may still be worth it. Your financial advisor can help you make this determination.

5. Keep the ILIT in Force

Once your ILIT has been set up and your life insurance policy acquired, there's very little to do. Each year (or as long as premiums are due), you'll transfer cash to the ILIT. The grantor transfers enough cash into the ILIT to pay the annual insurance premium. The trustee will use that money to pay the insurance premiums.

As long as the premium payment follows the "gifting" guidelines (described below), there will be no gift taxes. Neither the donor nor the beneficiaries will be subject to the gift tax.

The trustee will also oversee administrative duties such as notifying your beneficiaries that funds have been deposited into the trust by sending them a “Crummey Letter." The trustees will wait a specified time to see if the beneficiaries withdraw money. The trustee will send the premium payment to your life insurance company when they don't.

The trustee may also need to file a gift tax return. If your ILIT has earned income during the year, they might need to file an income tax return.

What If I Don't Want to Keep the ILIT in Force Any Longer?

Nothing requires you to continue making insurance payments. Depending on the policy, your coverage may lapse as soon as you miss your annual premium payment. Or, if your policy has cash value, those funds may be used to pay premiums until all the accumulated cash is exhausted.

The one thing you cannot do is transfer a policy owned by an ILIT into your name. If you think you may need to do that someday or want to access the policy's cash value, consider whether the ILIT is a suitable estate planning tool for your situation.

Will My ILIT Be Subject to Probate?

No, as long as the beneficiary of your trust is not your estate. Once the trustee provides your insurance company with proof of your death, the policy's proceeds are paid out directly to the trust. This payout generally occurs quickly, privately, and with no legal expenses incurred.

Will My ILIT Be Subject to Gift Tax?

The ILIT works so well because it takes advantage of the tax break allowed for yearly gifts, called the annual gift tax exclusion. Each year, a person can give away a certain amount of money to another person, gift-tax-free. The amount varies from year to year. In 2023, the annual gift tax exclusion amount is $17,000.

You can give gifts to as many people as you like. A married couple can give a combined gift of twice the exclusion amount to one person.

You may give someone more than the exclusion amount. The excess gift will be applied toward your lifetime estate tax exemption of $12.920 million (the 2023 limit). Make sure you are aware of the most current exemption amount for the tax year as it changes.

Free Review of Your Estate Planning Case

Trusts are popular estate planning tools. An irrevocable trust might be suitable for your estate plan, but there are no do-overs with an irrevocable trust. It's critical to consult with an estate planning attorney for legal advice before setting up your trust. Working with an experienced attorney, you can receive a free case review.

Take the first step in making an informed decision about the best estate planning option for your family. You can also get started on estate planning with our state-specific forms.