Life insurance, while a valuable asset, can unexpectedly inflate the size of an estate, potentially triggering estate taxes or unnecessarily prolonging the probate process; however, a properly structured Irrevocable Life Insurance Trust (ILIT) can be a powerful tool to avoid these pitfalls, ensuring your beneficiaries receive the full benefits quickly and efficiently.
What Happens if Life Insurance is Owned by the Estate?
When a life insurance policy is owned directly by an individual, the death benefit becomes part of their estate. In California, while there isn’t a state estate tax, the federal estate tax applies to estates exceeding a certain threshold (currently over $13.61 million in 2024). Even if the estate isn’t subject to federal estate tax, including the death benefit in the taxable estate can increase its overall value and potentially impact other financial planning goals. Furthermore, the life insurance proceeds will be subject to probate, which can be a lengthy and costly process. According to recent data, probate in California can take anywhere from six months to two years, and legal fees can range from 4% to 8% of the estate’s gross value – a substantial drain on assets that could otherwise benefit your loved ones.
How Does an ILIT Work?
An ILIT is an irrevocable trust created to own a life insurance policy. The grantor (the person creating the trust) transfers ownership of the existing policy, or applies for a new one, to the ILIT. The trust then becomes the beneficiary of the policy, and the trustee manages the proceeds according to the trust’s terms. This removes the policy from the grantor’s estate, as the trust, not the individual, owns the insurance. This is a particularly useful strategy for individuals with large estates or those concerned about minimizing potential estate taxes. It’s crucial to understand that once an ILIT is established, it’s generally irrevocable. This means you can’t easily change its terms or reclaim ownership of the policy. That’s why careful planning and expert legal advice are essential.
A Story of Unforeseen Consequences
I remember a client, Michael, a hardworking carpenter who’d built a successful business over decades. He had a substantial life insurance policy to protect his family, but he never considered how it would impact his estate. Upon his passing, his family was shocked to discover that the life insurance proceeds were subject to probate, delaying access to the funds they desperately needed. The probate process dragged on for over a year, and legal fees ate into the benefits, leaving his wife and children with far less than he’d intended. Had Michael established an ILIT earlier in life, this situation could have been entirely avoided.
A Story of Proactive Planning
Conversely, I worked with Sarah, a business owner who was acutely aware of estate planning issues. She approached me years before her anticipated retirement, concerned about the potential impact of her life insurance on her estate. We established an ILIT and transferred ownership of her policy to the trust. When she passed away, her family received the life insurance proceeds quickly and efficiently, without any probate delays or legal fees. The ILIT ensured that her wishes were fulfilled, and her loved ones were protected exactly as she’d intended. This proactive approach not only minimized financial burdens but also provided her family with peace of mind during a difficult time.
Understanding the “Double Step-Up” in Basis and Community Property
In California, as a community property state, assets acquired during marriage are owned 50/50. A significant tax benefit arises with the “double step-up” in basis. When one spouse passes away, the surviving spouse receives a step-up in basis for *both* their separate property and their share of the community property. This means the value of the assets is “reset” to the fair market value at the time of death, potentially minimizing capital gains taxes when the assets are later sold. An ILIT, when combined with community property planning, can further enhance these benefits, ensuring maximum financial protection for your beneficiaries.
Important Considerations and California Law
When creating an ILIT, it’s crucial to avoid the “three-year rule.” This rule states that if you transfer ownership of a life insurance policy to an ILIT within three years of your death, the proceeds may still be included in your estate for tax purposes. It’s also important to properly fund the trust, ensuring that it has sufficient assets to pay the life insurance premiums. Furthermore, the trustee must manage the trust according to the California Prudent Investor Act, making investment decisions with care, skill, and caution. Finally, while no-contest clauses are generally enforceable in California, they are narrowly construed and will only apply if a beneficiary files a direct contest to the trust without “probable cause.”
Don’t leave your loved ones vulnerable to unnecessary probate delays and expenses. A properly structured ILIT can be a powerful tool to protect your assets and ensure your wishes are fulfilled.
23328 Olive Wood Plaza Dr suite h, Moreno Valley, CA 92553Contact Steven F. Bliss ESQ. at (951) 363-4949 to schedule a consultation and learn how an ILIT can benefit your estate plan.
Take control of your legacy today – a well-planned estate is a gift that keeps on giving.