If you have a large estate, it may be subject to heavy federal and state estate taxes when it passes to your beneficiaries. However, there are ways to pass certain assets, including insurance policies, to your loved ones or favorite charities without giving the government a piece of it in the process.
One such strategy for life insurance policies is to create an irrevocable life insurance trust, or ILIT. In some cases, these vehicles can also be useful even to those who do not have a large estate to shield from tax. Below, we explain how ILITs work, along with their pros and cons, so you can decide whether one is a worthwhile option for you and your estate planning.
What is an ILIT (irrevocable life insurance trust)?
Understanding what an ILIT is begins with being familiar with what trusts are in general. They are fiduciary relationships in which one party holds an asset with an obligation to keep it or use it for the benefit of another party.
In plain terms, a trust involves passing an asset to a trustee (the person who manages the trust) so that they can hold it and eventually pass the asset to your beneficiaries. A trust can hold a range of valuable items, including cash, homes and other types of property.
How does an ILIT work?
An irrevocable life insurance trust is a special type of trust designed specifically for life insurance policies. Its purpose is to allow you to pass the benefits of your life insurance policy to beneficiaries without subjecting the value of the policy to potentially costly estate taxes in the process.
As a rule, since an ILIT’s purpose is to avoid estate taxes, you need to consider one only if your life insurance benefits are so sizable as to otherwise be taxed as part of a large estate. The federal government estate tax threshold for 2023 is $12,920,000, but you could be subject to estate taxes in your state as well. These state tax liabilities can vary, so you may want to consult a tax professional to evaluate your potential estate tax liability.
Revocable vs. irrevocable trust
The word irrevocable is an important one to understand when deciding whether an ILIT is right for you. It means as it sounds: Once you create and activate the trust, you can no longer change it, except in very specific legal situations.
Revocable life insurance trusts are different. They give you a lot of freedom to change the terms of the trust while you’re still living. That makes them potentially a better option if you haven’t yet made a final decision about who will receive your life insurance proceeds when you’re gone.
Such control over your estate is appealing, but there’s a catch. Revocable trusts are subject to estate taxes, whereas irrevocable trusts are not. This means you may need to decide whether it’s worth giving up the ability to make changes to your life insurance trust to avoid subjecting your death benefits to estate taxes.
What is an irrevocable beneficiary?
An irrevocable beneficiary is something slightly different than an irrevocable trust. It refers to a beneficiary of your life insurance coverage who cannot easily be taken off the policy.
When you name a person or charity an irrevocable beneficiary of your policy, they receive the following rights:
- They can't be removed as a beneficiary without their consent
- You can’t change their share of your death benefit without their consent
- They have to be notified if you decide to cancel the life insurance policy
The bottom line: when you name someone an irrevocable beneficiary, you can’t change their financial interest in your life insurance policy unless they agree to the changes. This has a similar effect to naming the person as a beneficiary in an irrevocable life insurance trust, but it has some flexibility that could be useful as an alternative to an ILIT in some situations.
For example, you might have several beneficiaries on your life insurance policy. You could name one as irrevocable, which would lock in their financial interest in the policy. Then the other beneficiaries could be deemed revocable. That would leave you free to make changes to their interests in the policy as you wish.
The benefits of setting up an irrevocable life insurance trust
Choosing between a revocable and irrevocable life insurance trust is as financially important as deciding between term and whole life insurance. In the next few sections, we’ll take a closer look at the pros and cons of ILITs to help you make your decision.
Planning and reducing estate taxes
One of the main reasons to create an ILIT is to reduce your estate tax burden. But make sure you’re actually able to benefit from these tax advantages. Your eligibility will depend on the size of the estate you’re leaving to your heirs – and the bar for that is high. The federal estate tax exemption threshold changes annually, but only estates worth upwards of $12 million are currently subject to the tax. Thresholds for state-based taxes vary by jurisdiction.
Ensuring proper distribution of assets
An ILIT is inflexible, but its unchangeable nature can also be an advantage. Once you create the trust, it can’t be changed. That ensures that your assets will be distributed fairly and according to your wishes no matter what happens.
The probate process is avoided
Even if you don’t have a large estate, creating an ILIT could still make sense if you want to keep the policy’s benefits out of any potential probate process. Probate means there’s an active legal dispute over your assets and how they’re bequeathed to others. When you set up an irrevocable trust like an ILIT, you get asset protection benefits that keep covered property out of any legal challenges to your wishes.
What to weigh before creating an irrevocable life insurance trust
There are some potential downsides to creating an ILIT. Here are three to consider.
Loss of control over the life insurance policy
The main disadvantage of an irrevocable life insurance trust is that you relinquish future control of the underlying insurance policy when you create one. You won’t be able to change your coverage or beneficiaries. You can essentially only decide whether to continue making premium payments or allowing the policy to lapse by stopping them.
Potential gift tax implications
While creating an ILIT can spare you of some tax liabilities, it can subject you to potential gift tax payments. That’s because attorneys typically structure the ILIT agreement so that your premium payments are considered to be gifts for tax purposes. The IRS’s current annual gift tax exclusion is $17,000, which means you can give this much to someone without triggering tax liabilities.
Policy premiums of greater than $17,000 per year, though, could create a situation in which you owe taxes on any amount you pay in premiums above that figure. Since the cap would be reached only with a relatively rich policy, the odds are against you exceeding it. But that could happen, especially for the type of high-worth individual who tends to favor ILITs.
The possibility of becoming unable to pay the premiums
It's vital to be sure you have enough funds to cover your premium payments in perpetuity. If you stop paying the premiums, the insurance company will typically cancel your policy, rendering the ILIT trust as essentially worthless.
If you have any doubt about being able to keep up with the premiums, err on the side of caution by getting a less expensive policy with fewer benefits.
How to establish an irrevocable life insurance trust
You create an ILIT in several steps. The first is to procure the life insurance policy itself. Then consult a planning professional or review our guide covering life insurance for beginners for help in deciding on the type and size of the policy. Once you’ve settled on what you need, research potential companies from which to buy; our list of the best life insurance companies can help in identifying those.
Once you’ve secured the life insurance policy you want, the next step is to create your irrevocable life insurance trust. Begin by choosing a trustee, which is the person or organization that will manage the trust on behalf of your beneficiaries.
You’re now ready to consult an attorney to draft the trust agreement and advise you on the legal aspects of the ILIT that are relevant to your situation. When the trust is activated, you will continue making premium payments for your life insurance policy. But if you pass away, the life insurance payout will now be distributed through the trust to reduce your estate tax liability.
How to fund an irrevocable life insurance trust
There are two ways to supply an irrevocable life insurance trust with funds. The first, more common option is to create an unfunded ILIT and begin to supply it with assets. You do that by making a gift to the trust totaling the value of a single annual life insurance premium. For example, if your premium is $10,000, you would transfer $10,000 to the trust so that the trustee could pay the premium when it’s time to do so. You then transfer that same amount to the trust every year thereafter.
An alternative to this annual funding approach is to set up something called a funded irrevocable life insurance trust. This involves transferring an income-producing asset to the trust and using the cash it generates to pay your life insurance premiums.
For example, you might have a rental property in your estate. You could transfer it to the trust and use the rental income it generates to pay your life insurance premiums, on a monthly or annual schedule. While this asset-based approach may be more convenient for some grantors, it might trigger some tax implications. To be safe, consult with a tax professional if you’re interested in a funded irrevocable life insurance trust.
How to terminate an irrevocable life insurance trust
Since ILITs are designed to create an ironclad financial commitment, you shouldn’t expect the process of terminating one to be easy or fast. Still, you do have options for discontinuing such an arrangement.
The most common strategy is to simply allow the life insurance policy in the ILIT to lapse by no longer making the premium payments to the life insurance company. This would make the ILIT effectively worthless, since the insurer would eventually cancel the policy, leaving no benefits to distribute.
However, allowing your life insurance policy to lapse would likely involve sacrificing the premium payments you had made to that point. In addition, the rules that govern trusts in your state could create obstacles to letting your trust lapse.
To be able to terminate your ILIT, then, state regulators may impose certain requirements. You might need to show that all parties to the trust have agreed with its termination. Alternatively, you may be obliged to show that a material change that no parties anticipated when signing the trust agreement occurred, and impacted the trust agreement.
Such a shift could include your state changing a material aspect of its tax law relating to estate taxation. Were that to happen, an attorney might be able to successfully argue that the change is sufficient to warrant the termination of the trust.
Whatever the tactic you employ, be prepared for a lengthy and potentially costly legal battle if you decide to discontinue the trust and a beneficiary of the trust fights that move.
Summary of what is an irrevocable life insurance trust, according to Money
Creating an irrevocable life insurance trust promises at least three potential benefits. It can help you reduce the tax burden on your estate, ensure your assets are distributed according to your wishes and avoid the probate process with your life insurance death benefits.
But this financial vehicle also comes with disadvantages. You won’t be able to change the terms of the trust easily, and it could create gift tax issues that impact your tax bill.
Given the complicated legal and tax ramifications of an ILIT, it’s best to talk to a professional before creating one. Such a person can answer your questions and guide you through the process to ensure you find the right agreement for your goals.