Fidelity Viewpoints August 2023

Ben Franklin said that in this world nothing is certain but death and taxes. Well, one product sits at the intersection of both—life insurance. It may not help you cheat death, but it may help manage taxes.

There are certain estate planning steps we should all take, including the creation of a will and a health care directive. But if you have enough wealth that you expect your estate to be taxed—at either the state or the federal level—you may want to consider more advanced strategies, including an irrevocable life insurance trust (ILIT). If you were to die in 2023, you could pass $12.92 million ($25.84 million per married couple) to your heirs without paying any federal estate tax under the Tax Cuts and Jobs Act of 2017.

Life insurance can help families provide funding to pay estate taxes and provide other benefits for protecting wealth. "There are countless reasons or scenarios in which an ILIT might be beneficial," says Matthew Metos, vice president in Fidelity Investment's Advanced Planning Group. "A common reason to create an ILIT as part of one's estate plan is to provide cash that can be used to pay estate taxes, as well as other debts and expenses, without the need to sell illiquid assets, such as real property or a business."

Providing flexibility to heirs

One of the main reasons people set up an ILIT is to help provide their heirs with flexibility in settling their estate. One difficulty heirs often face is a lack of cash to pay estate taxes. (The top federal estate tax rate for 2023 is 40%. Also, a number of states impose separate state inheritance and/or estate taxes.) As a result, heirs may be forced to sell real estate, stocks, or a family business to raise cash.

Aside from being an administrative headache to accomplish in the 9 months before estate taxes are due, selling assets may not conform with your wishes or those of your family. For example, heirs may want to keep the home, jewelry, or other assets you have passed on but they may be forced to sell them to raise cash. Or the timing could be inopportune—a slumping stock market or depressed real estate values could force the estate to liquidate assets at low values. Another hazard of a forced sale is the potential to trigger income with respect to a decedent2 —in essence, forcing your heirs to pay additional taxes in order to settle the estate tax bill.

Compared to owning the life insurance policy personally, a key advantage of an ILIT—verses the estate—being the beneficiary is that the assets owned by the ILIT will not be considered part of an estate for federal inheritance/estate tax purposes. Consequently, the heirs won't have to pay estate or inheritance taxes on the life insurance death benefits that are paid.

Although life insurance death benefits are generally exempt from income tax, they are not generally exempt from estate tax. Life insurance is subject to estate tax if the insured person owns or controls the life insurance contract. To help mitigate the impact of estate taxes, the ILIT has to own the life insurance policy—as well as be the beneficiary of the policy—so the proceeds pass outside of the estate. Using the ILIT as part of a person's estate plan may be a way to help ensure the insurance policy will not be included in their estate for tax purposes. If utilized properly, it can be a tax-savvy approach to providing liquidity to the estate.

WHO SHOULD CONSIDER A IRREVOCABLE LIFE INSURANCE TRUST?

Individuals anticipating having an estate which may exceed the threshold for exemptions at the federal and/or state levels) 2. Individuals anticipating that their heirs may need to access cash from their otherwise illiquid estate (avoiding to need to sell property or business assets to pay for taxes) 3. An individual wanting to provide management and protection of an inheritance on behalf of beneficiaries (minor children, a loved one with special needs, or a person who lacks maturity or financial savvy) 4. Individuals or trustees wanting a vehicle to help avoid probate (in an effort to protect privacy) 5. People who hope to protect their insurance benefits from divorce, creditors, and legal action against them and their beneficiaries.

Estate strategies to consider.

In 2023, the federal estate tax exclusion increased to $12.92 million per person or $25.84 million for a married couple that takes advantage of portability. This historically high exclusion amount has people questioning whether they still need an ILIT if their estate is valued below this exclusion. However, it's important to keep in mind that the federal estate tax exclusions are not permanent. If the laws are changed and the estate tax exclusions are lowered, the estate tax need for an ILIT could return. In addition, there may be a lower state estate tax exclusion amount in your state. As a result, your estate could have a state estate tax liability but not a federal estate tax liability.

While an ILIT can provide a number of potential tax advantages, creating one is not a decision to be entered into lightly. An ILIT is a complex legal arrangement whose creation requires professional assistance and there will be costs associated with creating and maintaining the trust. Generally, it is most effective when in place prior to buying the insurance. Remember, the trust is irrevocable and once it is set up, the creator of the trust, the "grantor," generally cannot terminate it, make changes to it, or withdraw the assets. The ability to change an irrevocable trust depends on state law and the trust provisions, or may need the permission of a court. If your estate may owe state estate taxes, federal estate taxes, or both, it may make sense to consult your tax advisor or estate planning attorney about an ILIT.

How an ILIT works

An ILIT is an irrevocable trust that purchases a life insurance policy on the grantor. If a couple sets up the trust jointly, the insurance policy purchased within the ILIT is usually a "survivorship" or second-to-die policy, so the death benefit won't be paid until the surviving spouse passes away.

When the grantor (or the surviving spouse) dies, the proceeds from the insurance policy flow into the ILIT and are eventually distributed to the trust beneficiaries, often the grantor's children, grandchildren, or other family members.

How the money in the trust is paid out to the beneficiaries depends on how the trust is structured. The beneficiaries might be able to access the money soon after the insured person's death, or the trust assets could be paid out incrementally by the trustee over time according to the trust's terms.

Making a gift count
Typically, premium payments for a policy owned by the ILIT are funded by gifts made by the grantor. To make sure that such gifts qualify for any available annual exclusions from the federal gift tax, beneficiaries of the ILIT are often given a short window of time after a gift is made—30 days is common—during which they may withdraw their share of the gift, up to the annual exclusion amount of $17,000 in 2023 per grantor (donor), per beneficiary. Beneficiaries must understand the overall estate planning goals and not to withdraw their gifts for this approach to be fully effective.

Choosing insurance to help provide flexibility to the executor or trustees

For the life insurance within the ILIT, either term life insurance or a form of permanent insurance, including whole life or universal life can be used. Many insureds choose permanent life, in part because the primary purpose of the ILIT is to transfer wealth to their heirs, which will only happen if the policy is still in force at the time of their death. If the insured outlives the term of the policy, the ILIT is essentially worthless.

Many insurance companies won't issue a term policy past a certain age, and many term policies do not extend beyond age 80. A universal or whole life policy, on the other hand, can provide coverage for a fixed annual cost for life while providing a guaranteed death benefit.

Most ILITs are funded through the purchase of a new policy rather than through the gift of an existing policy. If an existing policy is gifted to the ILIT, the insured must survive for 3 years after the gift before the assets will be excluded from the insured's estate for estate tax purposes. In comparison, if funded through the purchase of a new policy, proceeds of the policy will not be subject to estate taxes in the insured's estate, even if the insured dies immediately after the ILIT's purchase.

The projected tax liability of the grantor's estate and the type of estate assets are the primary factors in deciding how much insurance to purchase. An ILIT provides the money to cover the taxes and gives the executor the flexibility to dispose of assets when it's most advantageous to the heirs. It can also be a means to transfer sums of money to a particular beneficiary. The ILIT itself does not directly pay the taxes, but, rather, it can lend money or purchase assets from the estate to provide the estate with requisite liability.

2 more important considerations

Strength of issuer: "It's important to research the strength of the life insurance company issuing the policy. Because an ILIT could be in force for 30 years or longer, the grantor must have confidence that the insurance company will not go out of business during that time," says Tim Gannon, vice president at Fidelity Investments Life Insurance Company. "It's key to find a company that delivers the right balance of low premiums and high-quality credit ratings, so you can have peace of mind regarding your long-term decision," explains Gannon.

The right trustee: Choosing an experienced trustee is critical to administer the ILIT. Because of the crucial nature of paying premiums in a timely fashion to keep the policy in force, and handling details such as notifying beneficiaries when money is contributed to the trust, an experienced trustee is vital. The cost of setting up and administering the trust should also be an important factor to consider.

"Given the trustee's complex responsibilities, you will want to consider naming a trustee that brings experience, objectivity, and professional resources to help ensure that the trust is administered according to the terms of the trust," notes Metos. "If you think this advanced planning strategy is appropriate, you will want to work with an estate planning attorney to explore the benefits of an ILIT."