When it comes to estate planning, most people want two things: to keep as much of their wealth as possible in the family and to avoid paying Uncle Sam more than necessary.
Enter the Irrevocable Life Insurance Trust (ILIT) - a fancy legal tool that can help protect your assets, reduce estate taxes, and make sure your beneficiaries get the most out of your life insurance policy.
Sounds great, right? Well, buckle up because there’s a catch. Once you set up an ILIT, you can’t change your mind. It’s like sending a text and realizing too late that there’s no unsend button.
But…if done correctly, an ILIT can be a game-changer for taxable estates and help provide financial security for generations to come.
What is an ILIT?
In its simplest form, an ILIT is a trust that owns a life insurance policy on your behalf. Once it’s created, you (the Grantor) transfer ownership of the policy to the trust and say goodbye to control over it forever.
The trust then manages the policy and, upon your passing, distributes the proceeds to your beneficiaries according to the rules you set.
How ILITs Give Uncle Sam the Slip (Legally, of Course)
Without an ILIT, your life insurance policy is included in your taxable estate, having the potential to push its value over state or federal estate tax exemption limits.
And let’s be honest, no one wants their hard-earned wealth going to the government when it could be supporting their family members instead and no one purchases an insurance benefit hoping it won’t payout as intended.
By having an ILIT own the policy, you sidestep this issue entirely. When the payout comes, the proceeds go directly to the trust, tax-free, and will not be considered a portion of the grantor’s estate.
If structured properly, even the insurance premiums you pay can be considered tax-free gifts to the trust. That’s what we call a win-win. (We can elaborate more on this in a private strategy session).
The Benefits of Using an ILIT
Estate Tax Reduction. Keeps your life insurance policy proceeds out of your taxable estate, potentially saving millions in estate taxes.
Asset Protection. Shields the policy’s payout from creditors, lawsuits, and anyone looking for a quick payday.
Control Over Distributions. Want to prevent your heirs from blowing their inheritance on sports cars and questionable investments? You can set rules on when and how they receive their money.
Liquidity for Estate Expenses. Life insurance proceeds can help cover estate taxes, legal fees, or debts, so your heirs don’t have to sell off assets at bargain-bin prices.
Tax Filings. ILITs are usually structured as grantor trusts while you are alive, which means there are no separate tax return for the trust. Any taxable income earned in the trust will be picked up on your personal return each year.
For example, some ILITs hold taxable investments in addition to life insurance policies. The income generated from those investments are taxable to the grantor each year. Paying taxes on assets outside of your estate is not considered a gift, which makes this another great estate planning technique.
The Drawbacks of ILITs
Because they are irrevocable, there are no “take-backs” with ILITs, so this can be an intimidating decision. Once you transfer the policy to an ILIT, it’s out of your hands for good. No changing beneficiaries, no tweaking terms, and no second-guessing. Revocable trusts offer more flexibility, but may not offer the same benefits depending on your situation and desired outcome.
You’ll also want to consider your gift tax situation. Contributions to cover premiums might be subject to gift tax unless structured carefully within the annual gift tax exclusion.
Beware of the infamous ‘Three-Year Rule’ for an ILIT. If you transfer an existing policy into the trust and don’t live for another three years, the IRS will still count it as part of your estate. (So, maybe don’t take up skydiving right after signing the paperwork). But all jokes aside, this is a key reason to consider this trust option early with your attorney and wealth manager if you think it might be valuable to protect assets for wealth transfer.
Between legal docs, proper administrative work, and ongoing management, an ILIT isn’t exactly a DIY project. Get advice before considering this type of adventure.
When is an ILIT the Right Move?
Not everyone needs an ILIT, but if any of these sound like you, it’s worth considering:
You Have a High Net Worth. If your estate could be hit with estate tax, an ILIT can save your heirs from a massive tax bill.
You Own a Business. The proceeds can provide liquidity to cover estate taxes or ensure a smooth business transition.
You Want to Protect Beneficiaries. Whether your kids are too young, financially inexperienced, or just really bad with money, an ILIT lets you control how and when they get their inheritance.
You Care About Asset Protection. If lawsuits or creditors could threaten your estate, an ILIT keeps the insurance money safe.
Is an ILIT Worth It?
An Irrevocable Life Insurance Trust can be a powerful tool that helps wealthy individuals minimize estate tax, protect assets, and ensure their loved ones are financially secure. It can go far beyond what you might typically consider a “death benefit.”
But, the irrevocable nature means there’s no turning back once it’s established. If you’re comfortable with that level of commitment (and not prone to second-guessing yourself later), an ILIT can be a superstar for your estate planning strategy.
Takeaways & Other Types of Trusts
Keep in mind, your estate plan is unique – it’s never a one-size-fits-all deal. If you’re questioning if an ILIT might be right for you, consider looping an experienced wealth manager into the conversation with your estate planning attorney to help you navigate all of the fine print but also the larger strategy in conjunction with your financial plan.
There are a variety of unique types of trusts to consider beyond ILITs: Special needs trusts, self-cancelling installment notes (SCINs), Grantor Retained Annuity Trust (GRAT) just to name a few.
Your estate plan also goes way beyond a life insurance payout, it’s more akin to legacy planning. By definition, it covers quite literally everything you own, so it’s not a strategy to take lightly and partnering with a professional can be very helpful to avoid pitfalls, simply protect more of what you’ve earned, and deliver peace of mind.
Our estate planning guide will walk you through everything to consider as you get your plan in place. Check it out here or download it straight to your inbox by submitting the form below.
