An unmodifiable trust that holds a key asset — a life insurance policy.
An ILIT owns the insurance policy, and is usually the beneficiary, too
Death benefits can pay out to the trust, which then pays the trust beneficiaries
ILITs provide asset protection and prevent potential estate taxation
As of 2019, the estate tax exemption limit is $11.4 million
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 in to the value of your estate. Upon your death, if your estate is large enough, it might owe estate taxes.
If you’re concerned about reducing the size of your taxable estate, you might consider opening an irrevocable life insurance trust (ILIT). This is a specific kind of trust that can’t be altered. It is meant to hold one main asset — a life insurance policy — and help you avoid estate taxation, by having the trust own the policy and make the premium payments.
For this type of trust, "irrevocable" means its terms can't be modified without the expressed consent of the grantor and its beneficiaries.
A trust is used as part of estate planning, often in conjunction with or as an alternative to a will. A trust is a separate entity into which you can transfer your assets, eventually to be given to your future heirs. An ILIT is an irrevocable trust, meaning it usually can’t be altered — and specifically intended to hold a life insurance policy.
The trust holds the policy, and when you die, in most circumstances it will collect the death benefit and pay it out (make distributions) to your chosen trust beneficiaries.
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Most of the time, the purpose of the irrevocable life insurance trust is to lower the value of your taxable estate. (We’ll discuss in detail how taxes work with life insurance, and how an irrevocable trust helps avoid some of them.) Because the trust owns your life insurance policy, it also protects the proceeds from creditors.
Before we get into the unique benefits, here are the steps you need to take to get an irrevocable life insurance trust.
The person creating the trust is called the grantor or trustmaker. If that’s you, you’ll need to put money into the trust so that it can buy the life insurance policy and make the payments.
The trustee is the administrator of the trust. The grantor should not be the trustee; he or she should not retain any association or power over it to reap the full tax benefits.
Next, you’ll purchase a life insurance policy through the trustee. You are the insured; the trust is the policyholder. The trust should make the premium payments, not you.
If you already hold a life insurance policy, you can transfer it into the trust. The trust will become the new owner of your policy. If you’re doing this with the intention of reducing your taxable estate, keep in mind that the IRS has a three-year look-back period — if you die and the death benefit is paid out before three years have passed since you transferred the policy, your estate will not realize the potential tax benefits that come with an ILIT. This is because the proceeds will be considered part of your gross estate.
When you purchase a life insurance policy, you’ll need to designate who gets the death benefit (the life insurance beneficiary). With an ILIT, the grantor has the proceeds pay out to the trust (by naming the trust as the beneficiary). The grantor also makes rules for how the trust should make distributions to your heirs.
You can’t make changes to the beneficiary of the irrevocable life insurance trust. That’s why it’s considered irrevocable.
Upon your death, the life insurance company will pay the money out to the trust. The trust in turn will make distributions to your chosen beneficiary specified in the trust document. The beneficiaries may have to pay income tax on the interest earned from a distribution, but not necessarily on the death benefit itself.
When a beneficiary receives life insurance proceeds, he or she typically does not have to pay income tax on it.
However, a tax may be levied on the estate, called the estate tax, if the death benefit exceeds a certain amount.
When you die, the executor will determine the value of your estate — or the total gross assets. If the estate is valued over the 2020 estate tax exemption of $11.58 million, then the federal estate tax will have to be paid on any amount over the limit. Additionally, some states levy their own estate taxes. (The estate tax exemption will increase to $11.7 million in 2021.)
The value of a life insurance policy’s death benefit can actually contribute to the value of the estate. This happens when:
If the life insurance policy has no beneficiaries — they’ve predeceased the policy holder and there are no contingent or secondary beneficiaries, or the policy holder didn’t fill out the beneficiary form correctly — then the life insurance proceeds are redirected to become part of the estate.
If you had a will, the death benefit will become part of the residue of your estate, and it will be paid out to your beneficiaries according to the residuary clause of the will. If you didn’t have a will, the death benefit will be paid out to your heirs according to the intestacy laws of your state.
According to Section 2042 of IRS code, even if your death benefit makes its way to the intended beneficiaries, the dollar amount of the payout can be added to the valuation of your estate. This happens when the deceased retained, at the time of death, any “incidents of ownership” over the policy.
Examples of ownership include:
Holding the policy
The ability to change beneficiaries
The ability to borrow against the policy, as with cash-value life insurance
Acting as trustee or co-trustee, if a trust owns your life insurance policy
If you're unsure of the tax implications of a life insurance policy, you should consult with tax professionals for legal advice in better understanding your situation.
Properly set up, the irrevocable life insurance trust essentially prevents the value of the death benefit from being calculated as part of the taxable estate.
Normally, your death benefit is counted as an asset of the gross estate, but when you put the policy into an ILIT, you’re relinquishing ownership of it and any effect it might have on the estate tax.
When a life insurance policy has designated beneficiaries, the death benefit is paid out directly to them. While the death benefit does not become part of the estate, it can be included in the valuation of the estate for the purposes of determining the estate tax — if the deceased retained incidents of ownership, as per IRS code Section 2042.
With an irrevocable life insurance trust, the grantor-testator did not retain any incidents of ownership, so the benefit is not considered part of the estate for estate tax purposes. Recipients may be required to pay income tax on distributions.
When you’re funding the trust, you can use you might want to use something called the Crummey powers to your advantage. With Crummey powers, the money you use to fund the trust — or gift into the trust — can qualify for the federal gift tax annual exclusion up to $15,000 so long as you give the trust beneficiaries the limited right to withdraw contributions within a set time limit.
It isn’t mandatory for the trust beneficiaries to make withdrawals (only that they have the option to) and if they don’t, the money can be used towards the premium payments. The trust must provide Crummey notices to the beneficiaries that they can withdraw said contributions within the time limit.
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. An ILIT also requires you to sacrifice the ability to change its terms, and it might be costly to set up since it’s a trust. For many people, creating a strong will and perhaps a revocable trust may be enough. (Create a personalized will and revocable trust for just $280 with Policygenius.)
As a benefit, the ILIT, like other irrevocable trusts, offers asset protection — the life insurance proceeds will be protected from creditors. If you set up the trust to make distributions to your spendthrift son, and he falls into a lot of debt, his creditors cannot come after the life insurance payout while it’s in the trust.
If you have concerns, it is best to consult with an estate-planning attorney who can help come up with a plan specific to your needs.
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Elissa Suh is a personal finance editor at Policygenius in New York City. She has researched and written extensively about finance and insurance since 2019, with an emphasis in esate planning and mortgages. Her writing has been cited by MarketWatch, CNBC, and Betterment.
Elissa has a B.A. in Film Studies from Barnard College.
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