Irrevocable Life Insurance Trust Estate Planning

Learn How an ILIT Can Help You Avoid Estate Taxes

Family Estate planning document with stethoscope
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Many people aren't aware that the Internal Revenue Service can include proceeds from their life insurance policies in their estates for tax purposes when they die. But this 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 Exactly Is an ILIT? 

An ILIT is a type of irrevocable 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 for two reasons. First, the trust must be irrevocable, which means that you must fund it and step aside. You relinquish any right to make changes to it or to dissolve it. And second, acting as trustee would give you something called "incidents of ownership" because you would 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.

What Exactly Are Incidents of Ownership? 

If you owned the policy yourself, you could withdraw its cash value or change its beneficiaries at any point during your lifetime. This makes it your asset, so the IRS and some state taxing authorities will then include the proceeds of the policy in your estate, potentially making them vulnerable to estate taxes.

This is particularly the case if your estate is the beneficiary of the policy, but even if you name your son, daughter, spouse or someone else as beneficiary, the policy is an asset of your estate if you own it at the time of your death.

Estate Taxes 

The estate tax threshold is pretty high as of 2017: $5.49 million in value per estate.

But if you insured your life for $5 million and your other property is worth more than $490,000 at the time of your death, you would exceed this exemption. Your estates — and by extension, your heirs — would owe the estate tax on any value over $5.49 million.   

Typically, 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 would be taxable. 

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 beneficiaries you've named in your trust documents to receive them. If the proceeds are held in trust for the benefit of your spouse instead of going directly to her, she'll receive regular incremental payments rather than the lump sum of proceeds, so they can't be taxed as part of her estate, either.

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 this 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, but this 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, advising them that they can ask for their share of the money within a specific period of time. This gives them an immediate right to it. Of course, if they take the money, the premiums will go unpaid and they will no longer be your life insurance beneficiaries because the policy would lapse. This is usually sufficient encouragement for the beneficiaries to leave the money right where it is 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 if you wanted to cancel the trust is stop making payments for the premiums. The trust would then become an empty vessel when the policy lapses.