Irrevocable Life Insurance Trust (ILIT): What Can This Estate Planning Tool Do for You?

Irrevocable Life Insurance Trusts (ILIT) have been in use for decades as a strategy to lower estate taxes. However, since the Tax Cuts and Jobs Act of 2017 doubled the estate tax exemption (currently $12.92 million per person), these tools have fallen out of favor since fewer people expect to exceed these larger limits. If Congress fails to take action, the exemption limits will revert back to an estimated $7 million per person (adjusted for inflation) in 2025. This upcoming event and other factors are prompting many to take another look at using the ILIT as part of their estate planning strategy.

Please note: this article is intended to provide general information only. Always consult your tax and estate planning professional for advice and specific recommendations.

What Is an Irrevocable Life Insurance Trust (ILIT)?

An ILIT is a type of trust established during your lifetime and funded with one or more life insurance policies. By placing a policy into the trust, you can avoid having the death benefit included in your estate for federal estate tax purposes.

How Does an Irrevocable Life Insurance Trust (ILIT) Work?

ILITs are irrevocable trusts established to purchase and own one or more life insurance policies. A trust is a legal entity with its own rights, similar to a corporation. 

There are three legal parties to this type of trust:

• The Grantor. This is the person who creates the ILIT trust. The life insurance policy may only insure the Grantor's life.
• The Beneficiaries. These are the individual(s) or entities who will receive the trust assets as distributions after the Grantor’s death.
• The Trustee. This will be an individual or organization you appoint to manage the trust. The Trustee is responsible for paying annual insurance premiums, overseeing trust administration, and managing distributions from the trust. The trustee is a fiduciary, so you must select someone with the skills and knowledge to handle it properly.

The ILIT allows you to transfer or purchase assets, in this case insurance policies, for the trust. The trust then owns them, and you no longer do. When you pass away, the death benefit is paid directly to your trust. Then, the money from the life insurance benefits will be distributed to the trust's named beneficiary (or beneficiaries) in the manner you defined in the trust agreement.

What are the Estate Planning Benefits of ILITs?

An ILIT offers a range of potential benefits:

• The trust keeps your life insurance policy out of your taxable estate for federal estate tax purposes. That can help you reduce estate tax liability. 
• For those with larger estates, an ILIT can provide liquidity in the case of your death. The life insurance proceeds can be used to cover estate taxes or expenses which can prevent the need to sell other assets. This can be especially important for business owners or those who own significant real estate.
• An ILIT gives you an element of control in how life insurance proceeds are used. Through the trust document that you create, you can dictate both the utilization and distribution of the death benefit.
• An ILIT allows you to fully utilize the annual gift tax exemption by using those gifts to pay life insurance premiums within the trust.

Using ILITs to Help Protect Access to Government Benefits

As wealth advisors, there are many ways we help clients use an ILIT for estate planning when appropriate. One common application is in the case of a special needs child or disabled family member. An ILIT can be used to set aside funds to provide for the continued care of the beneficiary after your death. By purchasing a life insurance policy in the ILIT and being careful to control how distributions are used, you can designate funds that will be reserved for their care without interfering with their eligibility for government programs and benefits.

Asset Protection Benefits of the Trust

In today's world, litigation is always a risk to your assets. Even if you're not at fault or a claim has no merit, most affluent people and especially business owners can unfortunately expect to become enthralled in a legal situation from time to time. That's where good estate planning can pay dividends. By putting some of your assets into irrevocable trusts, they help put those out of reach of creditors, helping make you and your family a less attractive target. 

The ILIT can provide asset protection benefits since, generally, an ILIT is not subject to creditor's claims against an estate. According to Adam Abrahams in an article published on AmericanBar.org, "neither an ILIT beneficiary nor a creditor of a beneficiary has a right to demand a distribution from the trust or the right to attach a beneficiary’s interest in the trust."

What are the Potential Downsides of an Irrevocable Trust?

As you can probably see, an ILIT can act as an effective wealth transfer mechanism in an estate plan many times. However, like every financial strategy, there are always potential downsides that you should always weigh carefully before choosing to have a trust created. Here are potential drawbacks to using an ILIT that you should be aware of:

• Establishing an ILIT forces you to relinquish any right to the property in the trust. So, while you can specify the terms of the trust (which includes the initial setup of the beneficiaries and the conditions under which they receive the assets), once the policy is transferred to the trust, it can't normally be changed. That's because the trust now owns that property, not you.
• There are costs associated with setting up and maintaining an ILIT. These include professional fees as well as a requirement to file a gift tax return initially when the trust is funded (and possibly other tax returns in future years).You'll want to make sure the benefits outweigh the costs for it to make sense.

How Do You Fund an ILIT?

Buying a life insurance policy is relatively straightforward, but how does it work when you put it in an Irrevocable Life Insurance Trust?

You could purchase a policy and transfer it into an ILIT. However, there are usually no tax benefits in that case. And if you die within three years of transferring the policy to the trust, an IRS rule requires that any proceeds be included in your estate for tax purposes.

Another strategy that is usually more tax-efficient is to use the annual gift tax exclusion to fund the trust each year. This does require some coordination and education with heirs because once the funds are received each year, the beneficiaries of the trust will be notified. They will need to decline any withdrawal to ensure the funds would be available to pay the insurance policy premium.

FREQUENTLY ASKED QUESTIONS

When Does an Irrevocable Life Insurance Trust Make Sense?

This will obviously vary based on your unique circumstances, and determining this is part of the estate planning process. But there are specific instances where ILITs can be very helpful. One is for families passing on their business to the next generation. In the case of valuable businesses or real estate assets, the potential estate tax burden may be high. When you pass away, you want to make sure your family has the ability to pay all estate taxes without having to liquidate your business or other highly valued assets. An ILIT can help you accomplish that. You'll fund the trust with life insurance suffiicent to meet your estate tax obligations. Then, the life insurance payout can be used to take care of that liability when you pass away, leaving your business and other assets intact for your heirs.

Can I Transfer an Existing Life Insurance Policy into the ILIT?

Yes, it is possible to transfer an existing life insurance policy or policies into an Irrevocable Life Insurance Trust (ILIT). It is important to consult with a knowledgeable estate planning attorney to ensure that the transfer is done correctly, however. Be aware that the IRS has a three-year look-back rule, so the proceeds must be included in your estate for estate tax purposes if you pass away during that time frame.

How do State Estate Taxes work with ILITs?

The federal estate tax isn't the only concern for affluent Americans since some states levy their own separate estate tax. If you live in one of those states, you'll be faced with both state and federal estate taxes. In that case, the ILIT may be more instrumental in minimizing estate taxes. The life insurance death benefit within an ILIT can provide funds to cover these taxes and other expenses. 

Here's a good resource by the Tax Foundation for determining your state's regulations.

What is the 3-Year Rule for an ILIT?

The 3-year rule applies to certain life insurance policies held in an irrevocable life insurance trust (ILIT). If a policyholder transfers an existing policy to an ILIT and dies within three years, the policy will be considered part of their taxable estate.

This rule aims to prevent individuals from taking action specifically to avoid estate taxes. However, the rule doesn't apply to new policies purchased directly within the ILIT. Be sure you're working with a knowledgeable tax professional, attorney or financial advisor to ensure you are aware of all tax implications.

Are Irrevocable Life Insurance Trusts Grantor Trusts?

Irrevocable Life Insurance Trusts (ILITs) may or may not be considered grantor trusts. It depends upon how they were drafted. A grantor trust is a type of trust where the individual creating the trust, known as the grantor, retains certain control and benefits over the trust assets. In an ILIT, on the other hand, the grantor relinquishes all control and ownership of the life insurance policy and transfers it to the trust. This transfer is irrevocable, meaning that the grantor cannot change or revoke the trust once it is established. As a result, the ILIT is not treated as a grantor trust for tax purposes unless drafted specifically that way. Instead, it is considered a separate entity subject to its own tax rules and regulations.

Can an ILIT be Terminated?

An ILIT is a trust designed to hold life insurance policies outside of your taxable estate. While an ILIT is intended to be irrevocable, it can be terminated under certain conditions. These conditions typically include unanimous agreement from all beneficiaries and the grantor, as well as obtaining court approval. Be sure to consult a tax professional and estate planning attorney before attempting this, as terminating an ILIT must be done in compliance with state laws to avoid potential tax issues.

Does the ILIT Require a Specific Type of Life Insurance Policy?

The Irrevocable Life Insurance Trust (ILIT) does not require a specific type of life insurance policy. Instead, the ILIT allows individuals to choose the type of policy that best suits their needs and goals. This gives policyholders flexibility in selecting insurance products that align with their objectives, whether it be term life insurance, whole life insurance, or universal life insurance.

However, some features of policies may not be appropriate for these trusts, so be sure to consult an independent, licensed insurance professional to confirm eligibility for an ILIT.

The key requirement for an ILIT is that the policy must be irrevocably transferred to the trust, meaning that the policyholder no longer has control over the policy or its proceeds. By utilizing the ILIT structure, individuals can ensure that their life insurance policy is managed and distributed according to their wishes while also being omitted from their taxable estate for estate tax purposes. 

Key Takeaway

ILITs can be a valuable estate planning tool when used properly. Given the potential reduction of the federal estate tax exemption in 2025, it might be a good time to revisit your estate planning to see what would be most beneficial. If you're considering an ILIT or another type of irrevocable or revocable trust, it is critical it's done in the context of a comprehensive financial plan. At Holland Capital Management, our focus on deep planning helps you identify the best estate and tax planning strategies for your needs, so you can protect what you've built.