ILITs are life insurance trusts that legally own a life insurance policy. The grantor cannot revoke or amend the policy after it has been established.
What Is an Irrevocable Life Insurance Trust?
ILITs are legal entities that are established through a written or statute agreement to own a life insurance policy. The grantor, who is usually the person who created the trust, cannot revoke, or amend the policy after it has been established.
The ILIT is the beneficiary of the life insurance policy, and it holds the title to it even though the grantor is still alive. After the grantor passes away, the proceeds of the policy are distributed to the trust's administrators or trustees.
How an Irrevocable Life Insurance Trust Works
Life insurance can be used to transfer a premature death risk to an insurance company and provide financial support to the surviving family members. It can also help provide liquidity during a person's life, as physical assets can be sold tax-free at the time of death. However, its use in estate planning may be problematic due to its tax implications.
Although life insurance proceeds are generally not subject to federal taxes, they can still be subject to state and federal estate taxes when the assets are distributed to the surviving family members. This is because the income from the policy can be included in the total value of the person's estate. Some people have tried to exclude life insurance from their estate to minimize their estate tax liability.
An irrevocable life insurance trust can be used to minimize the estate tax liability of life insurance. If the policy is owned by a trust, the proceeds are not considered part of the estate, and this allows for tax relief.
An ILIT allows a trust to purchase a life insurance policy or transfer it to the trust. The document that establishes the trust will then appoint a trustee to manage the assets of the trust. The trustee will also provide the terms of the distribution of the benefits from the trust. Since the trust is irrevocable, it can't be changed after it's established.
Let's assume that John lived in Vermont and had a $1 million insurance policy and a $4 million home at the time of his passing in 2021. His gross estate value increased to $5 million after he died.
Although the $11.7 million estate tax exclusion is well below the federal estate tax rate of $11.7 million, John's estate would most likely be subject to state estate tax due to the state's estate tax exclusion. If he had an ILIT three years before he died, his policy would be valued at around $4 million and would be excluded from his estate, which would eliminate both state and federal estate tax liability.
Types of Irrevocable Life Insurance Trusts
There are two kinds of ILITs:
A funded ILIT is a type of trust that allows the trustee to use the insurance policy's premium to pay for the trust's expenses. However, this arrangement can also result in gift tax consequences if the additional assets are given to the trust.
An unfunded ILIT is a type of trust that relies on the grantor's life insurance policy for its funding. The grantor annually contributes to the trust to help the trustee 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:
The lower federal and state estate taxes are also beneficial for ILITs. The proceeds of the life insurance policy can be excluded from the grantor's estate, which reduces or eliminates both federal and state estate tax liability.
The asset protection provided by an ILIT eliminates the possibility of creditors placing a lien on the assets that are transferred to the trust. Also, the beneficiaries' creditors can't place a lien on the insurance proceeds if the funds remain in the trust.
The grantor can also dictate the trust's ultimate purpose and use of the funds. This allows them to control the financial decisions of the trust and ensure that the beneficiaries are satisfied with the terms of the agreement. For instance, if a beneficiary reaches a certain age, the insurance proceeds can be paid out according to the grantor's terms.
The drawbacks of an irrevocable life insurance trust include:
If the trust agreement is not in compliance with certain provisions, an ILIT could potentially trigger gift taxes on the withdrawals made by the beneficiaries. These include the so-called Crummey provisions, which allow the use of the gift tax exclusion.
The grantor's ILIT is also not allowed to be revoked or amended once it has been created. This makes it important that the beneficiaries and the attorney work together to structure the trust in a way that minimizes the risk of gift and estate taxes.
The three-year waiting period before the estate exclusion takes effect is also important for ILITs. The policy's proceeds can't be excluded from the estate if the death occurs within this period.
If a grantor passes away before the three-year waiting period expires, they can't immediately transfer their assets to a trust to avoid estate taxes. Therefore, it's important that they make estate planning plans now.
Administered through an irrevocable life insurance trust, the grantor's life insurance policy is owned by the trust.
An irrevocable life insurance trust is commonly used to minimize the estate taxes on the grantor's estate. It can also provide more money to the beneficiaries.
ILITs can either be funded with additional assets or unfunded, leaving only the insurance policy in the trust.
Disadvantages of ILITs should be considered. Among these are the three-year waiting period, the inability to amend the trust, and the risk of gift taxes if the agreement is poorly drafted.