Reasons to Use a Life Insurance Trust, or Keep the One You Already Have

A decade ago, when the estate tax exemption was much lower, the irrevocable life insurance trust (or “ILIT”) was a component of many (or even most) tax-aware estate plans.

It was common for physicians, attorneys, architects, engineers, and corporate executives to have insurance trusts, without necessarily knowing why that was so. Reassured by their attorneys and accountants that the trusts helped reduce estate taxes, their attention moved on to other things.

In the post-2010 world of a $5 million inflation-adjusted estate tax exemption, these same clients wonder whether they should keep their ILIT, and a new generation of clients wonders whether they need one.

In the low-exemption world, the answer was: “almost always.” In the high-exemption world, the answer is “why not?”

To see why the ILIT remains relevant in a range of situations, let’s consider its application to the two main types of life insurance: term and whole life.

Term policies offer coverage for a fixed period. If the insured dies during that period, the policy pays a benefit. If (as is usually the case) the person doesn’t die during the period, the policy’s coverage ends and no benefit is paid. Term coverage is priced to reflect the fact that as few as 1% of term policies pay a benefit. Accordingly, it’s much cheaper than the main alternative form of coverage: whole life.

When an insured is younger, premiums for traditional whole life (or “cash value”) life insurance are much higher than for term insurance, but the policy is usually designed to remain in force with a level premium no matter how long the insured lives. Over time, whole life policies build a cash value. This cash value is usually accessible on short notice, and guaranteed not to decrease.

Accordingly, cash value life insurance has traditionally been regarded by many as a place to stash “safe” money. Many policyholders “warehouse” cash value for later use in paying college tuition, wedding expenses, supplementing retirement income, or defraying long term care costs.

If these are the two main types of life insurance, how do they relate to ILITs?

If you own an amount of term coverage that might put you over the estate tax exemption threshold of $5.34 million, the same traditional reasons to use an ILIT come into play: it makes sense to keep the policy proceeds out of your taxable estate. That way, the same premium dollars leave more net-of-estate-tax wealth to your beneficiaries. Also, if a revenue-hungry government later reduces the estate tax exemption, the policy in the ILIT will be quietly waiting in the meantime, comfortably secure from potential estate taxation.

If you live in Kentucky and own a whole life policy that is building a cash value, the case for using an ILIT is even stronger. Kentucky is a state that “opts in” to Federal bankruptcy exemptions. These exemptions include up to $12,250 in cash value in any life insurance contract owned by the debtor, if the insured is the debtor or the debtor’s dependent.

Life insurance cash values have much stronger protection in certain states that “opt out” of the Federal bankruptcy exemptions. (Florida, for instance, is an “opt out” state that provides unlimited protection for the cash value in a policy on the life of a Florida resident.)

If they own insurance policies designed to build high cash values, Kentuckians who want to keep their “safe money” as safe as possible until they retire to the Sunshine State may find the incremental asset protection provided by an ILIT attractive — especially if an ILIT otherwise makes sense in a world with uncertain future estate taxation.