What is an irrevocable life insurance trust (ILIT)?

An irrevocable life insurance trust holds your policy so you can avoid estate tax

Elissa

By

Elissa Suh

Elissa Suh

Senior Editor & Disability Insurance Expert

Elissa Suh is a disability insurance expert and a former senior editor at Policygenius, where she also covered wills, trusts, and advance planning. Her work has appeared in MarketWatch, CNBC, PBS, Inverse, The Philadelphia Inquirer, and more.

Updated|5 min read

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If you have purchased a life insurance policy, that means when you die your beneficiaries will receive a sum of money called the death benefit. While the proceeds of a life insurance policy generally aren't taxable, they do figure into the value of your estate. If your estate is large enough when you die, it might owe estate taxes, which can cut into your beneficiary’s inheritance.

If you're concerned about reducing the size of your taxable estate, you might consider opening an irrevocable life insurance trust (ILIT). This type of trust is specifically meant to hold your life insurance policy and pay the premiums on your behalf. However, since the estate tax exemption limits are set in the millions, life insurance trusts mostly benefit people who are very wealthy.

Key Takeaways

  • Estates worth over $12.06 million in 2022 will owe federal estate tax.

  • An ILIT owns your insurance policy, which can be excluded from estate taxes.

  • If you open an ILIT, make sure to choose someone else to be the trustee.

  • The life insurance trust receives the death benefit after you die and pays it out to trust beneficiaries according to your instructions. 

Is life insurance taxable in a trust? 

When a named beneficiary receives life insurance proceeds, they typically don’t pay income tax on it. However, the value of a life insurance policy's death benefit can actually contribute to the value of the deceased’s estate, which may result in estate tax.

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When you die, the executor will determine the value of the assets in your estate. If your estate is valued over the exemption limit ($12.06 million in 2022), then the federal estate tax will have to be paid on any amount over the threshold. When someone retains any "incidents of ownership" over their insurance policy, the dollar amount of the death benefit can actually add to the valuation of their estate.

Examples of ownership described by Section 2042 of IRS code include:

  • Holding the insurance policy

  • The ability to change the life insurance beneficiaries

  • 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 

→ Read about when life insurance becomes part of an estate

One way to avoid having your policy proceeds factor into your estate is by using a life insurance trust. Life insurance trusts can help you avoid “incidents of ownership” so the benefit is not considered part of the estate for estate tax purposes. That's because the life insurance policy becomes trust property, and is no longer an asset owned by the policyholder.  

How an irrevocable life insurance trust (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 on to your future heirs. An ILIT is an irrevocable trust that holds a life insurance policy so that it doesn't factor into the policy owner's taxable estate. 

The way a life insurance trust works is that:

  1. You set up an irrevocable trust, which can't be altered. 

  2. You transfer your existing life insurance to the trust or have the trust buy a new policy and pay the premiums. 

  3. When you die, the life insurance company will pay the money out to the trust, which is excluded when calculating your taxable estate. 

  4. The ILIT in turn will pay out the policy proceeds to your trust beneficiaries, via the trustee, according to the terms in your trust document. 

→ Learn how trust assets are distributed to beneficiaries

In order for the irrevocable life insurance trust to work, it must abide by a few rules.

Life insurance trusts should be irrevocable 

Normally, your death benefit is counted as an asset of the gross estate, but when you put the policy into an irrevocable trust you're relinquishing ownership of it and any effect it might have on the estate tax. The grantor can't change the terms of the trust, including who the trust beneficiaries are and under what circumstances and conditions they receive the assets.

→ Learn how to set up a trust

The trustee of a life insurance trust cannot be the grantor

While grantors normally act as trustee of their living trust, they should appoint someone else to serve as trustee of their life insurance trust. They should also not act as co-trustee. When a grantor retains any association or power over their trust, the IRS will see it as a grantor-trust, which won’t help reduce your tax burden. 

Putting life insurance into the trust 

To have the insurance proceeds paid out to the trust, you need to name the trust as the life insurance beneficiary when you take out the policy.

If you don’t have life insurance yet, you can purchase a life insurance policy through the trustee. You’re the insured; 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 into the trust with a change of ownership form. Contact your insurer to make the ILIT the owner of your policy. In order to successfully get the tax benefits of a life insurance trust, you need to do this at least three years ahead of time before you die because of the IRS look-back period. If your death benefit pays out to the trust, but three years haven’t passed since you transferred the policy, the proceeds will still be considered your own property and count towards estate tax purposes. 

Gift taxes and Crummey powers

When you fund the trust, the money you transfer into it (like for premium payments) is technically considered a gift. Making enough gifts can result in having to pay gift taxes, which you can offset by adding Crummey powers to your trust. Crummey powers give the life insurance trust beneficiaries the right to withdraw contributions within a set time limit, and allow your transfers into an irrevocable trust to qualify for the annual gift tax exclusion. 

It isn't mandatory for the trust beneficiaries to make withdrawals — only that they have the option to. The trustee should provide notices to the beneficiaries about their rights.

Should I get an irrevocable life insurance trust?

The main reason to get an ILIT is to lower your taxable estate, but most estates won't encounter estate taxes unless they're very large. You don’t have to worry about estate tax unless you’re close to exceeding the $12.06 million dollar limit. However, a few states do levy their own estate taxes, and the exemption amounts are much lower. 

An ILIT also requires you to sacrifice the ability to change its terms, and it might be costly to set up — you'll need help from an estate planning attorney.

For many people, pairing their life insurance with a strong will and revocable trust can be sufficient for their estate plan instead.

One benefit of an ILIT, like other irrevocable trusts, is that it offers asset protection. The life insurance payout will be protected from your beneficiary’s creditors. If you set up the trust to make distributions to your spendthrift son and they fall into a lot of debt, their creditors cannot come after the proceeds held by the trust.

If you have more questions about whether an irrevocable life insurance trust is right for you, you can consult with an estate-planning attorney who can help come up with a plan specific to your needs.

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