The Irrevocable Life Insurance Trust

Life insurance is among the most common financial products bought in America. It provides consumers with an invaluable and cost-effective source of funds for loved ones. 

Life insurance proceeds may be used to replace a breadwinner's earnings, to ensure an important family goal (like a college education), or to cover burial costs or unpaid taxes.

But if your family is nearing the federal estate tax exemption amount, life insurance proceeds can push the value of the estate over the threshold.

Enter the Irrevocable Life Insurance Trust or ILIT.

Like most trusts, an ILIT is a holding device. It owns your life insurance policy for you, removing it from your estate. As its name suggests, an ILIT is an irrevocable trust. Once the grantor has created the trust document and named the trust as the beneficiary of the life insurance policy, the policy cannot be withdrawn.

ILITs and Estate Tax

Everything owned in your name at the time of death is included in the value of the taxable estate for estate tax purposes. That includes the death benefit proceeds of life insurance policies over a certain dollar amount. For large estates, insurance policies with death benefits in the hundreds of thousands of dollars can push the gross estate value beyond the taxable threshold, causing an estate tax liability.

An ILIT prevents death benefits from being added to your taxable estate because the insurance policies are owned by the trust, not your estate. Thus the estate tax liability isn't increased.

ILITs and Estate Planning

An essential part of wise estate planning is deciding not only who the heirs will be, but also how and when they will receive an inheritance. Life insurance provides an immediate and often considerable payout of cash to beneficiaries. Even adults with experience managing their finances may find a sudden windfall of money from a life insurance policy overwhelming.

The trust creator defines how the trust will operate. You can name beneficiaries and define how they will receive the life insurance payout.

  • If liquidity is needed, then a lump sum, one-time payment is the best option.
  • If beneficiaries of the trust are minors, a series of payments may be preferred by their guardian.
  • You can choose the trustee (or trustees) who will manage your ILIT. The trustee cannot be you. Here's why: In some states, creditors can seize the cash value of a life insurance policy to settle a claim against the estate. An ILIT provides asset protection. As an irrevocable trust, the donor cannot access the assets in the trust. They have been removed from his/her control. If you were a trustee, you would have some degree of control, or “incidents of ownership." The trust would then lose its ability to protect assets from creditors.
  • If your loved ones have demonstrated poor money management skills in the past, you may want to choose a trustee with wealth management experience and pay out assets over time.

ILIT Beneficiary's Access to Needed Government Benefits

If a beneficiary of an ILIT is a recipient of benefits under a government program, such as Medicaid, the proceeds from your life insurance policy could make your beneficiary ineligible for further benefits. Your beneficiary will only regain eligibility for government benefits once all the money from your life insurance has been spent, usually on basic needs.

An ILIT can protect access to needed government aid while allowing your insurance proceeds to be used for things like education, a home health aide, medical treatment not covered by Medicaid, etc.

To ensure access to government benefits, the trustee will retain ownership of the life insurance policy's proceeds so they can manage how the money is spent. The beneficiary will not own the proceeds outright.

How Do I Set Up an ILIT?

The process begins when you sit down with an estate planning attorney to design your ILIT. You will:

1. Name Your Beneficiaries

The choice is completely up to you, although most people name their children, grandchildren, or other close family members.

2. Name Your Trustees

Different types of trusts have different rules. Living trusts allow the grantor or the grantor's spouse, or both, to serve as trustees. That's not the case with an ILIT. If you or your spouse are insured by the life insurance policy owned by the ILIT, and you also serve as a trustee, the IRS may decide that the policy hasn't left your estate after all. That could impact your estate tax liability.

Name Someone Else as a Trustee

The trustee manages the trust following the directions set forth in the trust documents. Once you've passed away, the trustee will oversee the distribution of the policy's proceeds, according to the trust directives.

3. Determine the Conditions Under Which Your Beneficiaries Will Receive Money

Those conditions are really up to you. The policy's proceeds can be paid out immediately to one or all of your beneficiaries. Or your beneficiaries could receive monthly or annual distributions. You could dictate that beneficiaries receive money when they attain certain milestones, such as college graduation or getting married.

You can build in flexibility so that your trustee has the discretion to provide distributions when your beneficiary needs it most.

4. Acquire a Life Insurance Policy

The next step is to acquire a life insurance policy. You'll go about this process just as you would normally, except that the owner and beneficiary of your policy will be your ILIT. Also, you won't pay the insurance premiums directly. The trustee will pay premiums to the insurance company.

You can use an individual life policy, or, if you and your spouse are both living, you can use a second-to-die ("survivorship") policy. This kind of policy pays out a death benefit only after both spouses have passed away.

You can also use an existing insurance policy, however, if you die within three years of transferring the policy into the ILIT, the IRS will include the policy in your estate for estate tax purposes. Also, there are gift-tax considerations if an existing policy is used for an ILIT. Despite these issues, from a financial planning perspective, it may still be worth it to transfer an existing policy from your estate into an ILIT.

5. Keep the ILIT In Force

Once your ILIT has been set up and your life insurance policy acquired, there's very little that needs to be done.

Each year (or as long as premiums are due), you'll transfer cash to the ILIT. The grantor transfers enough cash into the ILIT to pay the annual insurance premium. The Trustee will take that money and use it to pay the insurance premiums. As long as the premium payment follows the "gifting" guidelines (described below) there will be no gift taxes incurred by either the donor or the beneficiaries.

The trustee will also oversee administrative duties such as notifying your beneficiaries of the fact that funds have been deposited into the trust by sending them a “Crummey Letter." The Trustees will wait a proscribed amount of time to see if the beneficiaries withdraw any money. When they don't, the trustee will send the premium payment to your life insurance company.

The trustee may also need to file a gift tax return or, if your ILIT has earned income during the year, they may need to file a tax return.

What If I Don't Want to Keep the ILIT in Force Any Longer?

There's nothing requiring you to continue making insurance payments. Depending on the kind of policy you have, your policy may lapse as soon as you miss your annual premium payment. Or, if your policy has cash value, those funds may be used to pay premiums until all the accumulated cash is exhausted.

The one thing you cannot do is transfer a policy owned by an ILIT into your own name. If you think that you may need to do that someday, or if you want to access the policy's cash value, you should reconsider the ILIT as an estate planning tool.

Will My ILIT Be Subject to Probate?

No, as long as the beneficiary of your trust is not your estate. Once the trustee provides your insurance company with proof of your death, the policy's proceeds are paid out directly to the trust. This payout generally occurs quickly, privately, and with no legal expenses incurred.

Will My ILIT Be Subject to Gift Tax?

The ILIT works so well because it takes advantage of the tax break allowed for yearly gifts, called the annual gift tax exclusion. Each year, a person can give away a certain amount of money to another person gift-tax-free. The amount varies from year to year. In 2022, the annual gift tax exclusion amount is $16,000.

You can give gifts to as many people as you like. A married couple can give a combined gift of twice the exclusion amount.

You may, of course, give someone more than the exclusion amount. The excess gift will be applied toward your lifetime estate tax exemption of $12.06 million (the 2022 limit). Make sure you are aware of the most current exemption amount for the tax year as it changes.

Questions About an Irrevocable Life Insurance Trust? Talk to an Estate Planning Attorney

Life insurance is one of the best ways to provide for your family and loved ones in the event of your death. Before you decide on an ILIT, speak to an experienced trust attorney who can explain your trust options as part of overall estate planning.

Can I Solve This on My Own or Do I Need an Attorney?

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