When you purchase life insurance, you set your beneficiaries up to receive a sum of money called the death benefit when you die. These proceeds generally aren’t taxable, but they do figure into the value of your estate. If your estate is large enough when you die, your beneficiaries will owe estate taxes, which can cut into the amount of inheritance they receive.
Wealthy individuals with large estates may wish to establish an irrevocable life insurance trust (ILIT) to reduce the size of their taxable estate. ILITs hold your life insurance policy, pay the premiums on your behalf, and completely avoid estate taxes and the probate process. They can even help ensure the funds are spent according to your wishes.
Life insurance and estate taxes
When a named beneficiary receives a life insurance death benefit, they typically won’t need to pay income tax on it or use it to settle the estate’s debts. However, the death benefit does factor into the value of the deceased’s estate for estate tax purposes.
If your estate is valued over the exemption limit ($12.92 million for individuals or $24.84 million for married couples in 2023), it will owe federal estate tax on any amount above that threshold. If you retain any “incident of ownership” over your insurance policy, the dollar amount of the death benefit — whether it's a lump sum or an annuity — may increase your taxable estate or push your estate's value over the exemption limit.
According to the IRS, examples of incidents of ownership include:
Holding the insurance policy
Having the ability to change life insurance beneficiaries
Having the ability to borrow against the policy, as with cash-value life insurance
Acting as trustee or co-trustee of a trust that holds your life insurance
One way to keep the death benefit from contributing to the value of your estate is to use an ILIT. Life insurance trusts help you avoid “incidents of ownership” because the life insurance policy becomes trust property and is no longer considered an asset held by the policyholder.
How an ILIT works
In estate planning, a trust is a separate entity that holds your assets like money, real estate, and personal belongings, which can eventually be passed down to your future heirs. An ILIT is an irrevocable trust that holds your life insurance policy (instead of you) so that it won’t factor into your taxable estate.
The trust acts as the policyholder, removing you from any incidents of ownership. The death benefit is no longer considered part of your estate and does not increase the value of your estate for tax purposes. It also won’t be subject to probate, the legal process of administering your estate. Your heirs can receive the death benefit in its entirety.
Here’s how the ILIT process works:
You set up an irrevocable trust that can never be altered.
You transfer your existing life insurance to the trust, or have the trust "buy" a new policy, then fund the trust so it can pay the premiums on your behalf.
When you die, the policy pays the death benefit to the trust, which is the beneficiary of the life insurance policy. The benefit is excluded from your taxable estate.
The ILIT will distribute the death benefit to your trust beneficiaries according to your wishes, as outlined in the trust document.
One stipulation to keep in mind is a three-year look-back period imposed by the IRS. If you die within three years of transferring the policy into the trust, the benefit still counts as part of your estate.
Also, if you're using a permanent life insurance policy, avoid contributing more than the federal limit to the cash value of the policy, or else the IRS will consider your policy a modified endowment contract and tax it at a higher rate.
When you fund the trust, the money you transfer into it for premium payments is considered a gift and is subject to a gift tax by the IRS. But you can avoid gift taxes on up to $15,000 in annual gifts by adding "Crummey powers" to your trust.
This gives your beneficiaries the ability to withdraw a limited amount of contributions from the trust within a certain period of time. They don’t have to make withdrawals, but they do have the option to do so.
How to set up an ILIT
ILITs are complex and come with many tax implications. It’s vital to consult an attorney when you’re setting up a trust to ensure it's properly implemented and works to your benefit. Once you’ve begun the process of setting up the trust, you’ll need to make a few key designations:
The grantor: the insured individual whose death prompts the death benefit payout.
The trustee: the administrator of the trust, who cannot be the grantor.
The trust beneficiaries: the recipients of the funds from the trust.
The actual process of setting up the trust involves these steps:
Open and finance the trust.
Fund the trust to maintain the life insurance policy’s premium payments.
Select a trustee.
Purchase or transfer a life insurance policy.
Designate how the trust will distribute the death benefit to your beneficiaries. These instructions are irrevocable and cannot be changed at a later date.
How to put life insurance into the trust
If you don’t have life insurance yet, you can purchase a life insurance policy through the trustee. You’re the insured, and the trust is the policyholder. The trust should make the premium payments, not you.
If you already have a life insurance policy, you can transfer it to the trust with a change of ownership form. Contact your insurance company to make the ILIT the owner of your policy. Remember that to successfully get the tax benefits of a life insurance trust, it must be set up at least three years before you die because of the IRS look-back period.
Who should have an ILIT?
The main reason to get an ILIT is to lower your taxable estate, but you won’t even owe federal estate tax in the first place unless it exceeds the $12.06 million limit (although some states do levy their own estate taxes with lower exemption limits). Another major benefit is that creditors cannot come after the proceeds held in a trust.
For this reason, ILITs are most suitable for individuals with a high net worth who want to prevent any unnecessary exposure to higher estate taxes. Parents who want the proceeds to benefit their minor children can also use an ILIT to ensure the benefit is spent on their child’s care and doesn’t get tied up in court.
Most people won’t need to incorporate the complexity of an ILIT into their end-of-life planning for things like covering the cost of a funeral or cremation, so pairing their insurance policy with a strong will and revocable trust will be sufficient for their estate plan. Because the trust cannot be changed after it’s established, it’s best for people with specialized estate planning needs.