7 Reasons for an Irrevocable Life Insurance Trust (ILIT)

An irrevocable life insurance trust (ILIT) is a trust established during the insured's lifetime to own and control a term or permanent life insurance policy or policies. It can also manage and distribute the profits paid out after the insured's death in accordance with the insured's desires.

An irrevocable life insurance trust also shields the benefits of a life insurance policy against estate taxes. Because it is irreversible, it cannot be changed or undone once produced.

An ILIT can hold both individual and second-to-die life insurance policies. Second-to-die insurance covers two lives and pays a death benefit only on the second death.

How an Irrevocable Life Insurance Trust (ILIT) Works

An ILIT consists of three parties: the grantor, trustees, and beneficiaries. The grantor usually creates and funds the ILIT. Gifts or transfers made to the ILIT are permanent, and the grantor relinquishes control to the trustee. The trustee oversees the ILIT, and the beneficiaries get distributions.

It is critical that the grantor avoid incidental ownership of the life insurance policy, and all premium payments should be made from an ILIT-owned bank account.

There may also be gifting issues if the policy being transferred has a substantial financial value. If there is any doubt about the grantor's capacity to obtain coverage and you want to confirm insurability before incurring the expense of having a trust formed, have the grantor apply for coverage and list the owner as a trust to be named.

Once the life insurance company has made an offer, the original application is replaced with a new one that correctly shows the trust as the owner. The policy will then be issued to the trust.

Minimizing Estate Taxes

If you are the owner and insured, the death benefit of a life insurance policy will be included in your total estate. However, when an ILIT owns life insurance, the death benefit proceeds are not included in the insured's gross estate and so are not liable to state or federal estate taxes.

If properly formed, the ILIT can provide liquidity to help pay estate taxes, as well as other bills and expenses, by purchasing assets from the grantor's estate or obtaining a loan. Lifetime gifts can also help lower your taxable estate by moving assets to the ILIT. 

Avoiding Gift Taxes

A correctly designed ILIT avoids gift tax repercussions since the grantor's contributions are considered gifts to the beneficiaries. To avoid gift taxes, the trustee must notify the beneficiaries of the trust, via a Crummey letter, of their opportunity to withdraw a portion of the contributions for a 30-day period.

After 30 days, the trustee may utilize the contributions to pay the insurance policy payment. The Crummey letter qualifies the transfer for the annual gift tax exclusion by treating the gift as a present rather than future interest, eliminating the need to file a gift tax return in most situations. 

In 2022, you can give $16,000 (up to $17,000 in 2023) to as many people as you like. The $16,000 includes all presents. A married couple can donate an individual a combined $32,000 (rising to $34,000 in 2023) every year, tax-free. There is no limit to the number of gifts a couple can make.

You can also donate more than $16,000 per year (up to $17,000 in 2023), with the excess used to your lifetime estate tax exemption of $12.06 million in 2022 and $12.92 million in 2023.

Government Benefits

The earnings from a life insurance policy owned by an ILIT can help secure a trust beneficiary's government benefits, such as Social Security disability income or Medicaid. The Trustee can exercise strict supervision over how trust distributions are used so that they do not interfere with the beneficiary's eligibility for government benefits.

Asset Protection

Each state has its own set of rules and limitations regulating the amount of financial value or death benefit that is protected from creditors. Any coverage in excess of these limits retained in an ILIT is normally shielded from the donor and/or beneficiary's creditors. The creditors may attach any payouts made from the ILIT.

Distributions

An ILIT trustee may have discretionary distribution abilities and control over when beneficiaries receive policy proceeds. The insurance money can be distributed immediately to one or more of your beneficiaries. Alternatively, you can determine how and when beneficiaries get distributions.

The trustee may also have the authority to make distributions when beneficiaries reach particular milestones, such as graduating from college, purchasing their first house, or having children. It really is up to you. This can be important in second marriages to assure wealth distribution, or if the grantor of the trust has minor children who require financial protection.

Legacy Planning

The generation-skipping transfer tax (GSTT) levies a 40% tax on both outright gifts and trust transfers to or for the benefit of unrelated persons more than 37.5 years younger than the donor, as well as related persons more than one generation younger.

A popular example is giving to grandchildren rather than children. An ILIT uses gifts to the trust to purchase and fund a life insurance policy, allowing the grantor of the trust to take advantage of the GST tax exemption.

Because the death benefit proceeds are excluded from the grantor's estate, successive generations of the family—children, grandchildren, and great-grandchildren—can benefit from the trust's assets without incurring estate or GST taxes.

Tax considerations

Irrevocable trusts have a separate tax identification number and a particularly aggressive income tax schedule. However, both the cash value and death benefit of a life insurance policy are tax-free. As a result, owning a policy through an ILIT does not raise any tax concerns.

An ILIT, if properly designed, can provide the trustee with access to the accrued cash value by making cost-effective loans and/or payouts while the insured is alive. However, if a death benefit has been paid and the proceeds remain in the trust, any investment income made but not given to the beneficiaries may be taxed.

The Bottom Line

ILITs are a powerful instrument that should be included in many asset management plans to guarantee that your policy is used as effectively as possible to benefit your family. Even with the federal estate and gift tax exemption of $12.06 million in 2022 (which rises to $12.92 million in 2023), it is still conceivable to owe state estate taxes. Many states begin taxing estates worth $1 million or less.