What Is an Irrevocable Life Insurance Trust?
An ILIT is a legal entity established under state law via a statute or written agreement to own a policy on the life of a grantor, which is typically the person who creates the trust. Crucially, the grantor cannot amend or revoke the ILIT after establishing it.
While the grantor is alive, the trust is the beneficiary of and holds the title to the policy. When the grantor dies, the trustee or administrator of the ILIT distributes the policy proceeds according to the terms of the trust.
How an Irrevocable Life Insurance Trust Works
Life insurance is an important tool that can be purchased to transfer the risk associated with a premature death from a policyholder to an insurer and financially provide for surviving family. It can also be used to provide liquidity of assets upon death, as physical assets need not be sold first to pay for estate taxes. Although life insurance is valuable in these respects, its use in estate planning can be problematic from a tax perspective.
Although insurance proceeds received by a beneficiary upon the death of the insured generally aren't subject to federal income tax, proceeds payable to the decedent's estate or heirs are included in the value of total property owned by the decedent at the time of their death (known as the "gross estate"), and may, in turn, be subject to federal and state estate tax. For this reason, many people look for a way to exclude their life insurance from their estate and thereby minimize or eliminate their estate tax liability. One potential way to do this is through the use of an irrevocable life insurance trust. If a trust (as opposed to you) owns your policy, and proceeds aren’t payable to your estate, it’s not considered part of your estate, allowing for relief from taxes on the value of the insurance policy.
Through the use of an ILIT, the trust can purchase the policy or the policy can be transferred to the trust. The trust document will appoint a trustee to administer the assets that are owned by the trust and will provide the terms under which they should be administered. The document will also designate beneficiaries and detail the terms by which the beneficiaries will receive benefits from the trust. Because the trust is irrevocable, it cannot be altered once it’s established.
The value of an ILIT can be best illustrated through an example. At the time of his passing in 2021, John lived in Vermont and had a $4 million home and a $1 million insurance policy, bringing his gross estate value to $5 million. Although that's well below the federal estate tax exclusion amount for 2021, $11.7 million, John's estate would ordinarily be on the hook for state estate tax, as Vermont's estate tax exclusion is only $5 million in 2021. If John had established an ILIT more than three years before his death, his policy would be excluded from his gross estate, valuing it at only $4 million and eliminating the federal and state estate tax liability.
Even if your estate isn't subject to federal estate taxes, it may still be on the hook for state estate taxes.
Types of Irrevocable Life Insurance Trusts
There are two kinds of ILITs:
- Funded ILIT: This is a trust funded with the insurance policy plus additional assets (such as cash) that can be used by the trustee to pay premiums. The downside of this arrangement is the possible gift tax consequence of contributing the additional assets to the trust.
- Unfunded ILIT: This type of trust is funded by the life insurance policy only, and no additional assets. Each year, the grantor must make annual contributions to the trust to provide the funds needed for the trustee to pay the premiums.
Pros and Cons of Irrevocable Life Insurance Trusts
The advantages and disadvantages of ILITs include:
Lower federal and state estate taxes
Asset protection against creditors
Increased asset control
Potential for gift taxes
Inability to change the trust agreement
Three-year waiting period before gross estate exclusion applies
The advantages of an irrevocable life insurance trust include:
- Lower federal and state estate taxes: Life insurance proceeds are generally excluded from the grantor's gross taxable estate, reducing or even eliminating the federal or state estate tax liability and leaving more funds behind for heirs.
- Asset protection against creditors: A grantor's future creditors can't place a lien on assets transferred to the trust, nor can a beneficiary's creditors place a lien on insurance proceeds as long as the proceeds remain in the trust.
- Increased asset control: The grantor, who cannot make changes to the trust agreement after it has been executed, can dictate the ultimate purpose and use of the trust assets. As such, the insurance proceeds will be paid out according to terms the grantor laid out (for example, when a beneficiary reaches a certain age), which can be particularly beneficial when passing on assets to family members who may not otherwise be financially responsible with the proceeds.
The drawbacks of an irrevocable life insurance trust include:
- Potential for gift taxes: If the trust agreement is drafted without so-called "Crummey provisions" that enable the use of the gift tax exclusion on ILIT withdrawals, an ILIT may trigger gift taxes when beneficiaries make withdrawals from the trust.
- Inability to change the trust agreement: By definition, the ILIT cannot be amended or revoked once the grantor has created it, making it all the more crucial to work with an attorney to structure the trust in such a way as to minimize estate and gift tax liability.
- Three-year waiting period before gross estate exclusion applies: The policy transferred to the ILIT may not be excluded from the gross estate within the three-year period ending on the decedent's date of death.
The three-year rule prevents, for example, a grantor who is soon to pass away from making an abrupt transfer of assets to a trust before their death to avoid estate taxes. That's why it's important to make plans for your estate (and if needed, establish an ILIT) as early as possible.
- An irrevocable life insurance trust is a type of trust that owns a life insurance policy on behalf of the trust's grantor.
- An ILIT is typically used to minimize estate taxes on the federal and state level, which leaves more money to heirs of the estate.
- ILITs can either be funded with additional assets or unfunded, leaving only the insurance policy in the trust.
- The benefits of an ILIT should be weighed against its drawbacks, namely the three-year rule, the inability to later amend the trust, and the potential for gift taxes if the agreement is improperly drafted.