What Is an Irrevocable Life Insurance Trust?
An irrevocable life insurance trust (ILIT) is a trust established during the lifetime of an insured that owns and controls a term or permanent life insurance policy or policies.
It can also administer and distribute the profits paid out upon the death of the insured in accordance with the insured’s preferences.
Furthermore, an irrevocable life insurance trust shields the benefits of a life insurance policy from estate taxes.
Because it is irreversible, it cannot be changed or undone once produced.
Individual and second-to-die life insurance plans can be owned by an ILIT. Second-to-die policies insure two people and pay a death benefit only if the second person dies.
Learn more about the seven reasons for establishing an irrevocable life insurance trust in the sections below.
How an Irrevocable Life Insurance Trust (ILIT) Works
The grantor, trustees, and beneficiaries are all parties to an ILIT. Typically, the grantor develops and funds the ILIT.
Gifts or transfers to the ILIT are perpetual, and the grantor relinquishes control to the trustee. The ILIT is managed by the trustee, and distributions are made to the beneficiaries.
It is critical for the grantor to prevent incidental ownership in the life insurance policy, and any premium paid should come from an ILIT-owned bank account.
If the policy being transferred has a substantial accrued cash value, gifting issues may arise.
If you have any doubts about the grantor’s capacity to obtain coverage and wish to confirm insurability before incurring the expense of having a trust formed, have the grantor apply for coverage and list the owner as a trust to be named.
When the life insurance company makes an offer, the initial application is updated with a new application that correctly shows the trust as the owner. The trust will then be issued the policy.
Once established and funded, an ILIT can serve many purposes including the following:
Minimizing Estate Taxes
If you own and insure a life insurance policy, the death benefit is included in your gross estate.
However, when life insurance is owned through an ILIT, the death benefit proceeds are not included in the insured’s gross estate and so are not subject to state or federal estate taxation.
The ILIT, on the other hand, can offer liquidity to help pay estate taxes, as well as other bills and liabilities, if correctly formed, by purchasing assets from the grantor’s estate or through a loan
In addition, by putting assets into the ILIT, you can lower your taxable estate.
Also read: 5 Life Insurance Mistakes That You Should Avoid
Avoiding Gift Taxes
A correctly designed ILIT avoids gift tax repercussions since the grantor’s contributions are treated as gifts to the beneficiaries.
To avoid gift taxes, the trustee must use a Crummey letter to notify the trust’s beneficiaries of their right to withdraw a portion of the contributions for a 30-day period.
The trustee can then utilise the contributions to pay the insurance policy premium after 30 days.
The Crummey letter qualifies the transfer for the annual gift tax exclusion by making the gift a present interest rather than a future interest, avoiding the need to file a gift tax return in most situations.
You can gift $16,000 (up to $17,000 in 2023) to as many people as you choose in 2022. The $16,000 totals all gifts.
A married couple can offer an individual an annual tax-free gift of $32,000 (rising to $34,000 in 2023). There is no limit to the number of gifts a couple may give each other.
Government Benefits
The revenues of an ILIT-owned life insurance policy might help protect the benefits of a trust beneficiary who receives government assistance, such as Social Security disability income or Medicaid.
The Trustee can carefully manage how to trust distributions are used so that they do not interfere with the beneficiary’s eligibility for government benefits.
Asset Protection
Each state has its own set of rules and limits on how much financial value or death benefit is protected from creditors.
Any coverage kept in an ILIT over these limitations is normally protected from the grantor’s and/or beneficiary’s creditors. However, creditors may attach any distributions made from the ILIT.
Distributions
The trustee of an ILIT may have discretionary distribution abilities and control over when beneficiaries receive policy proceeds.
The insurance money can be distributed to one or more of your beneficiaries immediately. Alternatively, you can indicate how and when beneficiaries will receive distributions.
The trustee may also choose to make distributions when beneficiaries reach specified milestones, such as graduating from college, purchasing their first house, or having a child.
It’s entirely up to you. This can be important in second marriages to ensure asset distribution or if the donor of the trust has minor children or requires financial protection.
Legacy Planning
The generation-skipping transfer tax (GSTT) levies a 40% tax on outright gifts and trust transfers to or for the benefit of unrelated persons more than 37.5 years younger than the donor or related persons more than one generation younger than the donor.
Gifting to grandchildren rather than children is a regular example.
An ILIT leverages the grantor of the trust’s GST tax exemption by using gifts to the trust to purchase and fund a life insurance policy.
Because the death benefit proceeds are excluded from the grantor’s estate, numerous generations of the family—children, grandchildren, and great-grandchildren—may benefit from the trust’s assets tax-free.
Tax Considerations
Irrevocable trusts have their own tax ID number and a particularly aggressive income tax schedule.
The cash value of a life insurance policy, on the other hand, is tax-free, as is the death benefit. As a result, there are no tax implications to owning a policy through an ILIT.
If properly designed, an ILIT can give the trustee access to the accrued cash value by making cost-based loans and/or dividends while the insured is still alive.
However, once a death benefit has been paid, any investment income produced and not given to the beneficiaries may be taxed if the proceeds stay in the trust.
What Is the Main Downside to an Irrevocable Trust?
The main disadvantage of an irrevocable trust is that it cannot be changed once it is established.
Whatever you put into the trust is no longer yours, which could have serious consequences down the road.
For example, if you put a house or a large sum of money in a trust with the intention of giving it to your heir, and then you unexpectedly need those assets in the future, there is nothing you can do to get them.
However, depending on the circumstances, the courts may dissolve an irrevocable trust.
When the Grantor Dies, What Happens to an Irrevocable Life Insurance Trust?
When the grantor dies, the life insurance trust continues to receive benefits, which are subsequently dispersed to the trust beneficiaries as chosen by the grantor when the trust was established.
What Is the Purpose of a Life Insurance Trust?
A life insurance trust’s primary goal is to minimise the value of an individual’s estate in order to reduce the estate tax paid on life insurance benefits transmitted from the grantor to the beneficiary.
Trusts shield assets from creditors.
Final Thoughts
ILITs are a strong instrument that should be considered in many asset management plans to assist guarantee that your policy is used to benefit your family in the greatest possible way.
Even with the federal estate and gift tax exemption at $12.06 million in 2022 (rising to $12.92 million in 2023), state estate taxes may still be owed.
Many states begin taxing your estate when it is worth $1 million or less.
