Estate Planning: The Irrevocable Life Insurance Trust (ILIT)

An ILIT can help you avoid estate taxes

Image shows two people going over an documents. Text reads: "What is an irrevocable life insurance trust (ILIT): an ILIT is one way to include the proceeds from their life insurance policies when they die—minus the estate tax bill. It's a type of living trust that's specifically set up to own a life insurance policy; You can't serve as a trustee of the trust—you can name anyone else you like when you form the trust"

The Balance / Kelly Miller

Many people aren't aware that for tax purposes, their estates might include the proceeds from their life insurance policies when they die. Depending on the value of the policy, that could invite an estate tax bill. But it's avoidable. It isn't an ironclad rule, and there are ways around it.

One option is to form an irrevocable life insurance trust, also known as an "ILIT," to take ownership of the policy.

What Is an ILIT? 

An ILIT is a type of living trust that's specifically set up to own a life insurance policy. You can transfer ownership of an existing policy to the ILIT after it's been formed, or the trust can purchase the policy directly.

You can't serve as trustee of the trust, however. The trust must be irrevocable, which means that you must "fund" it, placing the policy into its ownership, and step aside. You must relinquish any right to make changes to the trust or to dissolve it.

Acting as trustee would give you something called "incidents of ownership," allowing you to retain control over the policy. But your spouse, your adult children, a friend, or even a financial institution or an attorney can serve as trustee for you. You can name anyone you want when you form the trust. 

What Are Incidents of Ownership? 

If you owned the policy yourself and retained control of it, you could withdraw its cash value or change its beneficiaries at any point during your lifetime. That would make it your asset so the IRS and some state taxing authorities would therefore include the proceeds of the policy in your estate's value.

If the proceeds are significant enough, that could potentially make your estate vulnerable to estate taxes. That is the case if your estate is the beneficiary of the policy, but the policy would still be an asset of your estate if you own it at the time of your death, even if you name your son, daughter, spouse, or someone else as the beneficiary.

Estate Taxes 

The estate tax threshold is pretty high as of 2021: $11.70 million per estate. Estates must only pay taxes on their values over that amount. 

If you insured your life for $5 million, and your other property is worth more than $6.7 million at the time of your death, you would thus exceed this exemption. Your estate—and, by extension, your heirs—would owe the estate tax on any value over the $11.70 million threshold.  

Only very valuable estates have to worry about federal estate taxes, but some states also impose estate taxes with much lower thresholds. If your state's exemption is $1 million, the balance of your policy's death benefits plus the value of your estate could easily push it into the taxable range. 

Who Are the Beneficiaries of an ILIT?

The ILIT is normally designated as the insurance policy's primary beneficiary. Death benefits are deposited into the ILIT when you die and they're held in trust for the benefit of the individuals you've named in your trust documents to receive the money.

If the proceeds are held in trust for the benefit of your spouse, she would receive regular incremental payments rather than the lump sum of proceeds. They wouldn't be taxed as part of her eventual estate as they would if the lump sum were to go directly to her, assuming the money hadn't been depleted by the time of her own death.

Potential Complications 

If you die within three years of transferring your life insurance policy to your ILIT, the IRS will still include the proceeds in your estate for estate tax purposes. You can avoid that by having the trust purchase the policy on your life, then funding the trust with sufficient money over the years to pay the premiums. 

Gift taxes can also be a consideration because you're effectively giving the trust the money to pay for the policy each year, but that is avoidable, too.

Your trustee can simply send your trust's beneficiaries something called a "Crummey" letter each time you transfer money to the trust. This letter would advise them that they can ask for their share of that money within a specific period of time. As long as they have an immediate right to the money, the gift tax doesn't apply.

Of course, the amount you're giving the trust is negligible compared to the eventual proceeds of your policy, particularly if it's divided among several beneficiaries. If they take the money now, the premiums will go unpaid and the policy would lapse.

This is usually sufficient encouragement for the beneficiaries to leave the money with the trust so it can pay for the policy.

Dissolving the Trust 

You normally cannot undo an irrevocable trust after you've set it up. But because ongoing premiums must be paid to keep the life insurance policy in effect, all you'd have to do to cancel the trust would be to stop making payments for the premiums. The trust would then become an empty vessel when the policy lapses. 

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  1. “How Does an Irrevocable Life Insurance Trust Operate?

  2. Northwestern Mutual. “What Is an Irrevocable Life Insurance Trust?

  3. Highland Capital Brokerage. "Top 5 Responsibilities of An ILIT Trustee: The Importance of Policy Reviews."

  4. Nolo. “Transfer Your Life Insurance and Decrease Your Estate Tax.”

  5. IRS. “Estate Tax.”

  6. Tax Foundation. “Does Your State Have an Estate or Inheritance Tax?

  7. FindLaw. “The Irrevocable Life Insurance Trust.”

  8. Legal Information Institute. “26 U.S. Code § 2035. Adjustments for Certain Gifts Made Within 3 Years of Decedent’s Death.”

  9. Public.Resource.Org. “Crummey v. Commissioner of Internal Revenue.”

  10. Legal Assistance for Military Personnel. “Issues in Drafting Wills and Trust Agreement,” Pages 21-23.

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