Life insurance usually enjoys state statutory protection. But again, its protection depends on state laws. Still, if you own a large life insurance policy you may title your insurance policy to an irrevocable life insurance trust (ILIT). An ILIT is an irrevocable trust specifically designed to own life insurance. As with other trusts, the ILIT has a trustee, beneficiaries, and terms for distributions. Your ILIT would own your insurance policy and would be the policy beneficiary. When you die, your insurer pays the ILIT trustee who then distributes the proceeds to the ILIT beneficiaries. Your estate shouldn’tbe the beneficiary, nor should you retain other incidence of ownership.
An ILIT can be unfunded or funded. With an unfunded ILIT, the life insurance premiums are not fully paid. Future premiums are paid to the trustee who then pays the premiums. With a funded ILIT you transfer to the trust either a fully paid insurance policy or enough income-producing assets to pay future premiums. Whether your ILIT is unfunded or funded, the policy premiums must be directly paid from the trust. If you directly pay the premiums you lose the trust’s tax benefits and creditor protection. Since the ILIT is irrevocable, it protects the policy’s cash value, death proceeds and trust distributions. If life insurance isn’t fully creditor protected under your state laws, then an ILIT is essential.
As importantly, the ILIT can save you estate taxes because the ILIT – not you personally – owns the life insurance. Therefore, policy proceeds in the trust are notincluded in your taxable estate. This is why you save estate taxes. To illustrate, if you are single and die with a three million dollar estate which includes a one million dollar life insurance policy, and have a two million dollar death tax exemption; your estate would pay an estate tax on the one million dollars. If we assume an estate tax of about 50 percent, your estate taxes would be about $500,000. An ILIT eliminates the one million dollar life insurance proceeds from your taxable estate. Your estate saves about $500,000 because you reduced your taxable estate to zero. Also, the ILIT gives you greater control over policy distributions. For example, if you personally own your insurance, your insurance will directly go to the named beneficiaries when you die. An ILIT lets you control how and when the policy proceeds are distributed. Spendthrift, anti-alienation, discretionary distribution and other protective provisions in the trust can further protect the insurance proceeds from your beneficiaries’ creditors.
Do you have exposed cash that you do not foreseeably need? It may be smart to buy more life insurance. Of course, not everyone needs more life insurance, but life insurance may be a simple way to shield excess cash from creditors because every state at least partially creditor protects life insurance. Moreover, it can be a tax efficient way to build your estate, a retirement nest egg or simply a way to leave considerably more money to your beneficiaries.
Annuities and life insurance policies are only exempt in some states. Even in states that protect these assets, they are often only exempt if structured properly. In some states we must not only pay attention to who the policy’s insured person, owner and beneficiaries are, but we must also examine the wording of the policy before we can say with any certainty that the policy is exempt. For example, Utah protects life insurance proceeds, but only if the beneficiaries are the insured person’s spouse or children. Alabama protects life insurance from the claims of creditors of a policy’s beneficiary, but only if the beneficiary is someone other than the insured and the policy states that the proceeds are exempt from creditor attachment. Not surprisingly, many insurance policies don’t include such protective language. To further muddy the waters, some states address to what extent cash proceeds are exempt from attachment, and other states don’t. If a state is silent on whether proceeds are protected, does that mean the policy is only safe from attachment before it’s converted to cash? How long are the proceeds safe after they are received? If statutory law is silent, we must then look to case law, which of course will vary by state. In any case, to be as safe as possible we should never commingle insurance proceeds with other funds. They should be kept in a separate account so that they’re clearly identified and thus afforded the maximum protection under law.
Finally, we should consider fraudulent transfer law if planning is done after a creditor threat has already materialized. Some states have adopted fraudulent conversion laws to specifically address whether transforming an exempt asset to a non-exempt asset, such as insurance, in order to avoid creditors is fraudulent. If such a purchase is made after a creditor threat has arisen, the fraudulent conversion law (if a given state has such a law) tends to operate differently than fraudulent transfer law. This means that even if a transfer is not fraudulent under fraudulent transfer law, it may be fraudulent under fraudulent conversion law. Whether a transfer is fraudulent will vary from state to state.
