An irrevocable life insurance trust (ILIT) is a special trust that serves as both the owner and beneficiary of one or more life insurance policies. It is primarily a financial planning and estate planning tool that is used to protect assets (specifically a large life insurance death benefit) from being subject to estate taxes.
An ILIT may be right for you and your family if you have a high net worth and want to reduce your estate taxes in the future.
What You Should Know About Estate Taxes
In the United States, you have the right to transfer your property and assets to a beneficiary or beneficiaries after your death.
While you have that right, the federal government and certain states hold the right to tax the value of that property. The estate tax is collected against the fair market value of your property upon its transfer, if the value of your estate is high enough. While you won't pay the tax while you're alive, your estate might.
If your estate is subject to estate taxes upon your passing, the amount that your beneficiaries will ultimately receive may be greatly reduced. Most people prefer not to pay more in taxes than they absolutely need to, even after death, so for those families whose wealth may be subject to estate taxes, proper estate planning is crucial.
Understanding Exclusions and Exemptions
A will and adequate estate planning are crucial for anyone who wants to control where their property goes. But planning for possible estate taxes is essentially limited to families of a certain net worth, because of the current estate tax exemption limits and exclusions.
The marital exclusion dictates that surviving spouses who are U.S. citizens are eligible to receive an unlimited marital deduction, meaning that no estate tax will be due on any property or assets—including proceeds from life insurance policies—when transferred to a surviving spouse. There is also no limit on the amount of property that can be transferred to your spouse, either during your lifetime or after.
Due to the marital exclusion, estate taxes are not part of the estate planning equation until the surviving spouse passes away.
With the federal estate tax exemption, many families do not need to worry about paying estate taxes on transferred property, even upon the death of the surviving spouse. The estate tax exemption is the value of property, in terms of U.S. dollars, that a person can transfer to beneficiaries before the estate tax applies. It is essentially the amount that any one person can leave to others after death that will be free from estate tax. That exemption amount has been rising for years. It's at $12.06 million in 2022.
Both spouses are entitled to the exemption, and the first to die can pass on any unused portion to the survivor. So it may be time to start talking about estate tax reduction strategies if your and your spouse's joint net worth and gross estate value is projected to be above $24.12 million, or $12.06 million each. This may include an ILIT.
While estates valued at less than $12.06 million are not currently subject to federal estate taxes for 2022, this threshold generally changes yearly and could change drastically when the Tax Cuts and Jobs Act expires on December 31, 2025.
What Is an ILIT?
An irrevocable life insurance trust is an estate planning tool that allows for the possible exclusion of life insurance proceeds from the estate tax by acting as both the owner and beneficiary of life insurance policies.
If the legal owner of a large life insurance policy passes away, and their gross estate value is greater than the current estate tax exemption, then the death benefit from the policy would likely be subject to steep estate taxes. But with the ILIT serving as both owner and beneficiary, it essentially acts as an estate tax-shielding "middle man" between a life insurance death benefit and its intended beneficiaries.
In order for the life insurance proceeds to benefit those intended—perhaps the deceased's children—the ILIT has beneficiaries for whom the trustee will invest and administer the proceeds from the policy.
While an ILIT can help in transferring large life insurance proceeds estate tax-free and providing the cash to pay any applicable estate taxes on the rest of the estate, it does come with some disadvantages.
The Downsides of ILITs
By definition, an ILIT is irrevocable, which means once it's in place it cannot be reversed or amended. This is the key drawback to establishing an ILIT, because we all know that life and circumstances change frequently. But it's this very characteristic of ILITs that excludes the life insurance proceeds from estate taxes.
Since the trust is the owner of the insurance policies and cannot be revoked, the insured cannot be deemed as having incidents of ownership, which determines whether or not an asset can be subject to estate taxes.
Other drawbacks of ILITs include their complexity and the costs associated with not only establishing the trusts but also managing and maintaining them. Even so, for families whose estates are large enough to be potentially subject to estate taxes, an ILIT is something worth considering.
You should monitor your life insurance contract regularly to ensure that the policy does not lapse.
Would Your Family Benefit From an ILIT?
Since the primary purpose of an ILIT is estate tax reduction, consider whether—and the extent to which—your estate will be exposed to state and federal estate taxes upon your and your spouse's deaths. That is important if your net worth is at or near the federal exemption limit.
Because the estate tax rules undergo frequent changes, and your net worth itself may fluctuate greatly over time, you may need to periodically revisit a previous decision to forgo an ILIT. This is where an estate planning attorney and/or a financial planner can be of assistance.
How to Set Up an ILIT
If you decide that an ILIT is the best tax-reduction strategy for your family, you’ll need to work with an attorney to set up the trust. Ideally, you’ll select a lawyer who specializes in estate planning. In order to draft the trust document and put your estate plan in place, you must make several decisions, including the following:
- Who will be the trustee of the trust?
- Who will be the beneficiary of the life insurance proceeds?
- Will you be buying a new life insurance policy inside the trust, or will you be transferring an existing policy?
Once you make these decisions, you cannot change them, unlike with a revocable living trust. With an ILIT, you lose virtually all flexibility.
On the other hand, as long as you live at least another three years after you transfer a life insurance policy to the ILIT (no minimum longevity is required for policies the trust itself purchases), all of your life insurance proceeds will pass outside of your estate, potentially saving it a sizable tax bill.
- An irrevocable life insurance trust (ILIT) is a tool that is used to protect assets—specifically a large life insurance death benefit—from being subject to estate taxes.
- ILITs are generally used by families with a high net worth and gross estate value.
- An ILIT can help transfer large life insurance proceeds estate tax-free and provide the cash to pay any applicable estate taxes.
- The key drawback of an ILIT is that it's irrevocable, which means it can't be reversed or amended.