If you have family that financially depends on you, life insurance can be a very important part of your overall financial plan. Life insurance policies can provide the peace of mind that your family will be taken care of if something unexpected happens to you. But life insurance can be used for more purposes than to replace income after the death of the insured, it can provide liquidity to pay estate taxes, balance inheritances among family members, increase overall wealth, and prevent beneficiaries from having to sell assets such as business interests or real estate.

One thing that most people don’t know is that a life insurance policy can also be used as an effective way to protect assets. Much like a home, investments, and retirement accounts, life insurance policies are considered an asset. Just like other assets, the cash value of life insurance could be at risk from potential creditors and lawsuits. Fortunately, there are legal solutions that can provide asset protection to life insurance policies. This article will discuss strategies that can be used to ensure that life insurance policies are kept safe from future legal threats.

Life Insurance Creditor Protection

The laws regarding life insurance creditor protection are complex and often confusing, even for judges and experienced attorneys in the field. The courts have established that barring fraud, the death benefit of a life insurance policy is protected from creditors. That applies to the beneficiary’s creditors, the policy owner’s creditors, and the creditors of the insured. Modern life insurance, however, often focuses more on the cash value of the policy rather than the death benefit. Today, insurance companies can make policies where funds can be deposited, grow tax free, and then be used for retirement.

Whether the cash value of a life insurance policy receives the same protection as the death benefit is unclear. Unfortunately, the major court cases have only addressed the death benefits, not the cash value aspect of insurance policies. Asset protection for life insurance policies also vary by state, some states offer no protection at all while others grant complete exemptions for life insurance. Additionally, most states’ life insurance exemption laws have one or more conditions that must be fulfilled to receive any protection at all, as well as exclusions that act as potential pitfalls.

Because products such as whole life and universal life insurance policies are more recent inventions, there is lack of clarity on how much legal protection, if any, they are likely to receive in the event of a lawsuit. For these reasons, we cannot presume that income streams from high cash value life insurance are protected from creditors under the law.

Irrevocable Life Insurance Trusts

In order to protect life insurance policies, attorneys created a special type of trust called an Irrevocable Life Insurance Trust (ILIT). As many other asset protection solutions, an ILIT is an irrevocable trust which means it generally cannot be altered or undone after it’s made. With an ILIT, the settlor deposits cash into the trust, which is in turn used to purchase life insurance, the trust then owns and controls a term or permanent life insurance policy or policies. Since the life insurance policy is held in the trust, the grantor no longer owns the policy, it will instead be managed by the trustee on behalf of the beneficiaries.

Using life insurance policies held in an ILIT allows you to protect wealth from creditors and judgments, which can become a major risk for high-net-worth clients. An ILIT also has the benefit of decreasing the value of an individual’s estate in order to reduce a future estate tax liability on the insurance proceeds. Since an ILIT is an irrevocable non-grantor trust, policy benefits are not included in the insured’s taxable estate for federal estate tax purposes.

How an Irrevocable Life Insurance Trust is Created

happy family signing documents for life insurance

An ILIT is a complex legal document that should be drafted by an experienced attorney and signed before any premium payments are made. An ILIT needs to contain specialized language including the terms and conditions for holding the insurance policy as well as language to ensure compliance with current tax laws and regulations. The grantor will need to nominate a trustee to manage the trust, this will often be a professional fiduciary with experience in managing trusts such as ILITs. The trust can also include rules the beneficiaries should follow when the death benefit is paid.

Once the trust is prepared, the grantor transfers funds into the trust, these funds are then used to pay for the policy premiums.  The ILIT is named as owner and beneficiary of the insurance policy issued on the grantor’s life. Accurate ownership of life insurance policy is important both for federal tax as well as asset protection purposes. As with other irrevocable trust, an ILIT should apply for and obtain its own taxpayer identification number.

How an Irrevocable Life Insurance Trusts Works

After the ILIT is established and the insurance premiums paid, you now have a valuable asset held within an irrevocable trust. The trustee will be responsible for ensuring the policy premiums are paid and the policy is otherwise kept effective. The grantor needs to be careful to avoid any incident ownership in the life insurance policy in order to maintain the integrity of the ILIT. The payment of premiums should always be made by the trust, never by the grantor himself.

If the trust needs funds to pay premiums, the grantor can make additional transfers into the trust. When assets are gifted to an ILIT, the trustee must send a special notification to the beneficiaries known as a Crummey letter. The Crummey letter lets the beneficiaries know that they have the right to receive the gift proceeds. Normally, the beneficiaries know that if they withdraw the gifts, the life insurance premiums will NOT be paid, and they will lose the life insurance policy.

Modern life insurance policies include provisions to allow the insured to borrow for medical or late-in-life expenses and help safeguard retirement savings. These important benefits are not necessarily lost just because the policy is held in an ILIT. If the grantor ever wants to borrow money from the policy during his lifetime, such as in retirement there are special types of ILITs that allow this. The caveat is that any borrowed funds will need to be repaid to the policy.

What Happens When the Grantor Dies?

stack of coins notebook stethoscope and heart in wooden table

Once the insured passes away, the death benefit is paid into the trust. At this point, the trust continues to operate under the management of the trustees, and they can proceed to pay the beneficiaries under the terms of the trust. If the trust was structured to pay out over a certain period of time, it can remain in effect until all the trust funds are exhausted or until a termination event is reached. Keeping the funds in trusts ensures that asset protection features are preserved for the beneficiaries as well.

If there is an estate tax outstanding, it generally should not be paid directly by funds held by the ILIT. Since the ILIT was formed in order to remove assets from the estate, doing so risks bringing the assets held in the ILIT back into the decedents’ estate, which would increase the tax liability. Instead, many ILITs are drafted with swap power provisions, allowing the ILIT to substitute illiquid assets such as real estate, business interests, or cryptocurrencies, for funds obtained from the insurance proceeds. After the assets are swapped, then the funds can be used safely for tax liabilities.

Life Insurance and Offshore Trusts

A life insurance policy can also be held by an offshore asset protection trust managed from an offshore jurisdiction such as the Cook Islands. Offshore trusts provide the highest levels of asset protection because they are beyond the jurisdiction of U.S. courts. An offshore trust is similar to an ILIT in that it must own and pay for the life insurance policy, and the trust should be named as the beneficiary on the policy. When purchased through a Cook Island Trust you can rest assured that your life insurance policy will benefit from the highest level of asset protection against judgments and creditors.

Additional Protection for your Life Insurance

Life insurance can play an important role in your overall financial portfolio. It can preserve what you’ve worked hard to achieve and help provide the capital needed to maintain your family’s lifestyle. As with so many things in life, insurance only works if it is there when it is needed. With proper planning, life insurance policies can be protected from lawsuits, creditors, and other legal threats. If you are considering a large cash value life insurance policy, you might want to think about legal solutions that could help safeguard your investment.

An experienced asset protection attorney can help you make the best choices for your situation so that your wealth is better protected. If you have more questions about asset protection strategies for life insurance policies or other assets, contact our experienced team at Blake Harris Law to create your asset protection plan. Call us today at 833-ASK-BLAKE, email us at Info@BlakeHarrisLaw, or fill out our contact us form.