Understanding Irrevocable Life Insurance Trusts (ILITs) in Estate Planning
Creating a lasting legacy that reflects your values, ensures the financial security of your loved ones, and minimizes tax burdens is the goal of an estate plan. For those with substantial estates, a specialized trust called an Irrevocable Life Insurance Trust, or ILIT, could be a critical tool in achieving those goals.
What is an ILIT?
An Irrevocable Life Insurance Trust is designed to own a life insurance policy. The "irrevocable" nature of the trust means that once you set it up and transfer assets to it, you generally cannot change its terms or reclaim the assets. An ILIT is usually created and funded by the grantor, and the grantor is giving up control to the trustee.
Once the ILIT is the legal owner of the policy, the proceeds from the policy are kept outside of your taxable estate. The trust, as administered by the trustee, controls the policy. When the grantor passes away, the death benefit is paid to the trust, which can distribute those proceeds according to your wishes to your beneficiaries.
Why Use an ILIT?
The reduction or elimination of estate taxes is the primary motivation for creating an ILIT. Life insurance death benefits can be substantial, and without an ILIT, those proceeds are included in the taxable value of your estate. If your estate exceeds the federal or state estate tax exemption limit, this could result in a significant tax bill. The federal estate tax exemption amount is $13.61 million for 2024 for an individual and double that for a couple. State tax exemptions vary by state. An ILIT shelters the proceeds of a life insurance death benefit from being taxed as part of your estate, allowing your beneficiaries to inherit more of your wealth.
Other benefits and reasons to use an ILIT include asset protection, control over distribution, and estate liquidity. An ILIT protects life insurance proceeds from creditors because the assets no longer belong to the grantor once they are transferred into the trust, where they may be shielded from the claims of creditors. Trusts offer the grantor control, and ILITs are no exception to this rule. The ILIT allows grantors to establish rules regarding how and when beneficiaries will receive proceeds. An ILIT can offer liquidity to help cover estate taxes, probate costs, or other expenses without forcing the sale of valuable family assets; this could be particularly difficult in the case of real estate, a family business, or other assets that are not easily converted into cash.
Setting Up and Using an ILIT Effectively
Step 1 - Create the Trust: An estate planning attorney will draft the trust. The ILIT document will outline the terms of the trust and name trustees (who will manage the trust) and beneficiaries (who will receive proceeds from the trust). The trust must be irrevocable and cannot be modified, nor can the assets be reclaimed; this requirement allows the life insurance proceeds to be excluded from your taxable estate.
Step 2 - ILIT Ownership & Beneficiary Designation: Once the trust is established, the ownership and beneficiaries of an existing life insurance policy need to be updated to the ILIT. Please be aware that there is a three-year "lookback" period. If the grantor passes within three years of transferring a policy, the proceeds will be included in their taxable estate. The ILIT can be the original owner and beneficiary if a new policy is purchased.
Step 3—Funding the ILIT: Premiums must be paid to maintain the life insurance policy. Typically, grantors will make annual gifts to the ILIT to cover these premiums. The trustee must notify the ILIT beneficiaries of these contributions and give beneficiaries the option to withdraw the funds. This process, known as "Crummey powers," allows contributions to qualify for the annual gift tax exclusion by satisfying a present interest requirement for beneficiaries. Beneficiaries typically understand that the trustee will use the dollars in the ILIT to pay the life insurance premium and do not exercise their right to the contributions, as this could result in the ILIT not having enough funds to pay the life insurance premiums.
Step 4 - Disbursement of Proceeds: When the grantor passes away, the life insurance company pays the death benefit to the ILIT, not the estate. The trustee will then manage and distribute the proceeds according to the terms of the trust. These proceeds are not subject to estate tax, allowing more dollars to be passed on to beneficiaries.
Is an ILIT Right for You?
An ILIT can be a powerful tool for individuals with significant life insurance policies or large estates that may face estate taxes. It offers tax savings, asset protection, and controls on distribution of proceeds to help ensure your life insurance proceeds are used according to your wishes. However, because an ILIT is irrevocable and, once established, cannot be changed, it's essential to consider your estate planning goals and consult with professionals to align your estate planning strategy to your long-term financial and legacy goals.