Life insurance is an important tool used in estate planning. Many people know that life insurance death benefits are not taxable, however many do not know that death benefits and cash value amounts can be included in the taxable estate. A properly managed irrevocable life insurance trust can ensure that the life insurance benefits are not included in the estate.
What is an irrevocable life insurance trust (ILIT)?
An irrevocable life insurance trust (ILIT, pronounced "eye-lit") is a trust that holds and controls one or more life insurance policies. The trust is the owner and the beneficiary of the life insurance policies. The grantor, who is typically the person who created and funded the trust, is also the insured, the person covered by the life insurance policy.
For an ILIT to work properly, the insured cannot own or control the insurance policy, and cannot be the trustee of the trust. The ILIT is also irrevocable, which means the terms of the trust cannot be changed. After the insured passes away, the trustee of the ILIT manages and distributes the death beneficiary per the terms of the trust. The trustee is generally a close family member or friend. In some cases, grantors will name an independent trustee to help offer greater flexibility for estate planning purposes.
What is the purpose of an ILIT?
The main purpose for an ILIT is to minimize estate taxes and provide liquidity to the beneficiaries.
Minimize estate taxes
The primary benefit of an ILIT is to remove the value of the life insurance policies in the trust from your taxable estate when you pass away. If you are both the owner and the insured of a life insurance policy, then the life insurance death benefit is included in your gross estate. If the owner is the ILIT, however, then the life insurance death benefit is not included in your gross estate and as a result is not subject to taxes.
So if a person has assets of $10 million and has on top of that a $5 million dollar life insurance policy, then the total taxable estate is $15 million. The basic exclusion amount for estate tax purposes in 2022 is $12,060,000, up from $11,700,000 in 2021. Taking into account the exclusion amount, the estate taxes owed would be close to $1.2 million. If the ILIT is the owner of the life insurance policy instead, then the taxable estate would be $10 million. Since the taxable estate amount is below the exclusion amount, there would be no estate taxes incurred.
Liquidity for beneficiaries
Funding an ILIT with life insurance can provide liquidity and cash for beneficiaries. If a person has a high net worth, the death benefit can provide the cash needed to pay the estate taxes, debts, and other expenses after the insured passes away. The beneficiaries will not be forced to sell real estate or other illiquid assets to free up cash. An ILIT can help provide liquidity if you want your beneficiaries to preserve a closely held business or other unique asset that they might have to liquidate to pay estate taxes and expenses.
Who are irrevocable life insurance trusts for?
High net worth individuals
ILITs are best suited for high net worth individuals whose assets will be subject to high estate taxes. ILITs can help those whose assets, including life insurance, will be significantly larger than the exclusion amount. The value of the ILIT is not included in the taxable estate and the death benefit is paid to the ILIT free of estate tax.
Business owners
If the bulk of your assets are in a business, there may not be enough liquidity to pay estate taxes and other expenses. If you don't want your beneficiaries to sell any part of the business, then an ILIT can help provide the liquidity needed to cover the taxes. The death benefit can be paid out immediately to the beneficiaries who can then use the funds to pay the estate tax and other administrative expenses.
Individuals who want to equalize inheritances
If you have multiple beneficiaries but only have a unique asset that can't be evenly distributed like a family farm or business, then the ILIT can help equalize the inheritance. ILITs create a pool of different assets that can be distributed based on equal value. So one child can receive the family business and the other child can receive the proceeds from the ILIT to make the inheritance equal.
What are the benefits of an irrevocable life insurance trust?
In addition to moving proceeds of life insurance policies out of a taxable estate and providing liquidity for your beneficiaries, there are other benefits of an irrevocable life insurance trust.
Gift tax exclusion
The most common way to pay for the insurance premiums in an ILIT is through the annual gift exclusion. For 2022, the annual gift tax exclusion is $16,000. With the ILIT, you can gift up to the $16,000 max for each beneficiary. In order to qualify for a gift however, the beneficiary must have the right to use the money.
The IRS will not consider the $16,000 transfer to the ILIT to be a gift unless the beneficiary has a "present interest" in the gift. Present interest means the beneficiary has unrestricted access and immediate use of the funds. Since the beneficiaries will benefit from the insurance policy, the benefit does not constitute a "present interest."
An ILIT allows the grantor's contributions to qualify as an annual exclusion gift. If the beneficiaries have the power to withdraw the contributions for a period of time, then they can qualify as "present interest." To do this, when creating the ILIT, the trust must use "Crummey Powers." Named after a court case, this gives beneficiaries the right to withdraw the money within a certain time period, usually within 30 days. If the beneficiary does not withdraw the funds, then it can be used by the trustee to pay the policy premium. This allows the grantor to pay the premiums without reducing the lifetime gift tax exemption amount.
Trustee oversight
An ILIT gives you the ability to direct the trustee on how the death benefit can be distributed. If you have young children, you can specify how and when they are to receive their distributions so they are protected. You can also give the trustee the discretion to grant distributions on certain key milestones such as college, marriages, or buying a home. The trustee can also help prevent irresponsible spending.
Through the terms of the trust agreement, you can decide how you want to distribute the assets in the trust. If you have multiple beneficiaries and assets that are difficult to split evenly, an ILIT can help equalize the inheritance amount.
Asset protection
An ILIT can help protect assets from creditors. Life insurance proceeds are typically protected from creditors of ILIT beneficiaries until they receive the assets. While each state has its own laws on how much is protected, coverage above certain legal limits held in an ILIT are generally protected from creditors of the grantor or beneficiaries.
Another purpose of an ILIT is to provide effective management of the trust, you can ensure that the insurance proceeds are properly managed. If the funds are not distributed immediately, the trustee can work with financial institutions to help invest and grow the assets.
What are the drawbacks of ILITs?
While there are numerous benefits of ILITs, there are some disadvantages that people need to be aware of.
ILITs are irrevocable
One of the major drawbacks is that when you create an irrevocable trust, you must give control to the trustee and cannot change the terms of the trust. You have no control to retrieve or even manage the insurance policies you assign to an ILIT. While there may be unforeseen changes, you are not able to change the ILIT to align with the future circumstances.
ILITS can be complex
For ILITs to work properly, they need to follow the laws. Any mistake can mean the life insurance proceeds are pulled into the estate. For example, to avoid gift taxes, the trustee must send out the Crummey letter to the beneficiaries notifying them of the option to withdraw the funds. If the beneficiary decides to take that option, then there may not be enough funds to pay the life insurance premiums. There are numerous rules that the trustee must ensure are being met or they risk the trust being dissolved.
Estate exemptions are higher
The estate tax exemption has risen dramatically the past 15 years. In 2008, the annual exemption was $2 million. The estate tax exemption has grown by six-fold since then to $12,060,000 for 2022. Since the exemption is much higher, many people may not need to create an ILIT.
How do you get an irrevocable life insurance trust?
To establish an ILIT, the grantor will first need to form the trust. The terms and conditions of the ILIT are set forth in a trust agreement which typically is prepared by an experienced tax or estate planning attorney. Once the trust is established, the grantor can either assign existing life insurance policies to the ILIT, or the ILIT can purchase the life insurance policies.
The trust will become the owner and the beneficiary of the life insurance policies. The grantor must also choose a trustee they can trust to carry out his wishes. The trustee will then need to make sure the insurance policy premiums are paid and the ILIT continues to follow all of the legal guidelines.
Creating an Irrevocable Life Insurance Trust (ILIT) can dramatically increase the liquidity of your estate, leverage the value of the annual $16,000 gift tax exclusion, and help ensure the proceeds of life insurance policies in an ILIT are not included in your estate. ILITs can provide an effective way for you to achieve multiple estate planning goals.
