People buy life insurance for many reasons, and it offers some unique features that are not found in many other financial products. For example, leverage, especially in the early years of a policy, where you pay a small premium to lock in a large death benefit or the ability to time liquidity to an event (the death benefit).
What Is an Irrevocable Life Insurance Trust (ILIT)?
An irrevocable life insurance trust (ILIT) is created to own and control a term or permanent life insurance policy or policies while the insured is alive, as well as to manage and distribute the proceeds that are paid out upon the insured’s death. An ILIT can own both individual and second to die life insurance policies. Second to die policies insure two lives and pay a death benefit only upon the second death.
An ILIT has several parties: the grantor, trustees, and beneficiaries. The grantor typically creates and funds the ILIT. Gifts or transfers made to the ILIT are permanent, and the grantor is giving up control to the trustee. The trustee manages the ILIT, and the beneficiaries receive distributions.
It is important for the grantor to avoid any incident ownership in the life insurance policy, and any premium paid should come from a checking account owned by the ILIT.
If the grantor transfers an existing life insurance policy to the ILIT, there is a three-year lookback period in which the death benefit could be included in the grantor's estate.
There can also be gifting problems if the policy being transferred has a large accumulated cash value. If there is a question about the grantor being able to obtain coverage and you want to verify insurability before paying the expense of having a trust drafted, have the grantor apply for coverage and list the owner as a trust to be named.
Once the life insurance company has made an offer for a new application, properly listing the trust as the owner can be submitted, replacing the initial application. The policy will then be issued to the trust.
Once established and funded, an ILIT can serve many purposes including the following:
Minimizing Estate Taxes
If you are the owner and insured, then the death benefit of a life insurance policy will be included in your gross estate. However, when life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and thus not subject to state and federal estate taxation.
If properly drafted the ILIT can, however, provide liquidity to help pay estate taxes, as well as other debts and expenses, by purchasing assets from the grantor’s estate or through a loan. Also, lifetime gifts can help reduce your taxable estate by transferring assets into the ILIT.
Avoiding Gift Taxes
A properly drafted ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries. To avoid gift taxes it is crucial that the trustee, using a Crummey letter, notify the beneficiaries of the trust of their right to withdraw a share of the contributions for a 30-day period.
After 30 days, the trustee can then use the contributions to pay the insurance policy premium. The Crummey letter qualifies the transfer for the annual gift tax exclusion by making the gift a present rather than future interest, thus avoiding the need in most cases to file a gift tax return.
In 2020 and 2021, you can give $15,000 a year to as many people as you like. The $15,000 encompasses all gifts. A married couple can give an individual a combined $30,000 annually, gift-tax free. There is no limit to the total number of gifts a couple may make. You can also give someone more than $15,000 a year with the excess being applied toward your lifetime estate tax exemption of $11,580,000 for 2020 and $11,700,000 for 2021.
Having the proceeds from a life insurance policy owned by an ILIT can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid. The Trustee can carefully control how distributions from the trust are used so as not to interfere with the beneficiary's eligibility to receive government benefits.
Each state has different rules and limits regarding how much cash value or death benefit is protected from creditors. Any coverage above these limits held in an ILIT is generally protected from the creditors of the grantor and/or beneficiary. The creditors may, however, attach any distributions made from the ILIT.
The trustee of an ILIT can have discretionary powers to make distributions and control when beneficiaries receive the proceeds of your policy. The insurance proceeds can be paid out immediately to one or all of your beneficiaries. Or you can specify how and when beneficiaries receive distributions.
The trustee can also have the discretion to provide distributions when beneficiaries attain certain milestones, such as graduating from college, buying a first home, or having a child. It’s really up to you. This can be useful in second marriages to ensure how assets are distributed or if the grantor of the trust has children who are minors or need financial protection.
The generation-skipping transfer tax (GSTT) imposes a tax of 40% on both outright gifts and transfers in the trust to or for the benefit of unrelated persons who are more than 37.5 years younger than the donor or to related persons more than one generation younger than the donor.
A common example is gifting to grandchildren instead of children. An ILIT helps leverage the grantor of the trust’s generation-skipping transfer (GST) tax exemption by using gifts to the trust to buy and fund a life insurance policy. Since the proceeds from the death benefit are excluded from the grantor’s estate, multiple generations of the family—children, grandchildren, and great-grandchildren—may benefit from the trust's assets free of estate and GST tax.
Irrevocable trusts have a separate tax identification number and a very aggressive income tax schedule. However, the cash value accumulating in a life insurance policy is free from taxation as is the death benefit. So there are no tax issues with having a policy owned in an ILIT.
If properly designed, an ILIT can allow the trustee access to the accumulated cash value, by taking loans and/or distributions on a cost basis, even while the insured is alive. However, once a death benefit has been paid, if the proceeds remain in the trust, any investment income earned and not distributed to the beneficiaries could be taxed.
The Bottom Line
ILITs are a powerful tool that should be considered in many wealth management plans to help ensure that your policy is used in the best possible way to benefit your family. And even with the federal estate and gift tax exemption at $11,580,000 ($11,700,000 in 2021), it is still possible to owe state estate taxes. Many states begin taxing your estate at $1 million or less.