The Irrevocable Life Insurance Trust

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

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

Life insurance proceeds can help:

  • Replace a breadwinner's earnings
  • Fund an important family goal (such as a college education)
  • Cover burial costs or unpaid taxes

Receiving insurance benefits after an insured person's death can offer a much-needed financial lifeline. Insurance proceeds can ensure your loved ones can maintain their standard of living. This is a good thing.

But when an estate's value is close to the federal estate tax exemption amount, life insurance proceeds can push the estate's value over the limit. When this occurs, the tax law will impose liability on the estate.

Enter the Irrevocable Life Insurance Trust (ILIT). Like most trusts, an ILIT is a holding device. For example, you can fund a revocable trust with real estate. A revocable trust can be changed or revoked by its creator or “grantor." Such a trust would own your real estate to benefit the beneficiaries of the trust.

An ILIT owns your life insurance policy. That means the policy will no longer be a part of your taxable 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has created the trust document and named the trust as the life insurance policy beneficiary, the policy cannot be withdrawn.

ILITs and Estate Tax

The value of the taxable estate for estate tax purposes includes everything owned in your name at the time of death. That includes the death benefit proceeds of life insurance policies over a certain dollar amount. Insurance benefits can push the gross estate value beyond the taxable threshold for large estates. This can cause an estate tax liability.

An ILIT keeps the life insurance proceeds out of your taxable estate. Insurance policies that fund an ILIT are trust assets. The trust, not your estate, owns the insurance policies. Thus, the estate tax liability doesn't increase.

ILITs and Estate Planning

An essential part of wise estate planning is deciding on your heirs. An estate plan also considers how and when the heirs will receive an inheritance. Life insurance provides an immediate and often considerable payout of cash to beneficiaries. Even financially responsible adults 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 determine how they will receive the life insurance payout.

  • If liquidity is needed to give heirs access to funds right away, a one-time lump sum payment is the best option.
  • If beneficiaries of the trust are minors, their guardian may prefer a series of payments.
  • You can choose the trustee (or trustees) to 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. The trust assets are out of their control. But 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 poor money management skills, choose a trustee with wealth management experience.

ILIT Beneficiary's Access to Government Benefits

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

An ILIT can protect access to government programs. At the same time, your insurance proceeds can fund things like:

  • Education
  • A home health aide
  • Medical treatment not covered by Medicaid

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

How Do I Set Up an ILIT?

To start the process, you'll work with an estate planning attorney to design your ILIT. A financial advisor can also help you with tax planning and choosing the right amount of life insurance. Your estate planning attorney will help you establish and fund the trust. Next, 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, 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.

The trustee you name will manage the trust following the directions outlined in the trust documents. Once you've passed away, that person will oversee the distribution of the policy's proceeds. The trustee must distribute the assets 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 heirs. Or they could receive monthly or annual distributions. You could dictate that beneficiaries receive money when they attain certain milestones. Typical life moments include graduating from college or getting married. Your trustee can be flexible and 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 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 only pays out a death benefit after both spouses have passed away.

You can also use an existing insurance policy. But 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, transferring an existing policy from your estate into an ILIT may still be worth it. Your financial advisor can help you make this determination.

5. Keep the ILIT in Force

Once your ILIT has been set up and your life insurance policy acquired, there's very little to do. 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 use that money to pay the insurance premiums.

As long as the premium payment follows the "gifting" guidelines (described below), there will be no gift taxes. Neither the donor nor the beneficiaries will be subject to the gift tax.

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

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

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

Nothing requires you to continue making insurance payments. Depending on the policy, your coverage 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 name. If you think you may need to do that someday or want to access the policy's cash value, consider whether the ILIT is a suitable estate planning tool for your situation.

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 2023, the annual gift tax exclusion amount is $17,000.

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

You may give someone more than the exclusion amount. The excess gift will be applied toward your lifetime estate tax exemption of $12.920 million (the 2023 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.

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