What is an irrevocable life insurance trust (ILIT)?

Irrevocable Life Insurance Trusts (ILITs) are legal vehicles established specifically to own one or more life insurance policies and are set up during an insured’s lifetime. ILITs are created to own a life insurance policy and keep its proceeds out of the insured’s or owner’s estate to avoid increasing the size of their estate when the insured dies.

When an individual owns an insurance policy (whether on his or her life or the life of another individual), the insurance policy is included in the individual’s estate at death and is therefore subject to federal estate tax (to the extent the estate exceeds the federal estate tax exemption). The federal estate tax is imposed at 40%, which can drastically reduce the insurance proceeds available to surviving family members. However, if the policy is held in a properly-structured ILIT, the policy is excluded from the individual’s estate, and the proceeds are fully preserved for the surviving family members.

Insurance is typically purchased to either: create an estate or, preserve an estate.

Insurance to create an estate

In the case of creating an estate, let’s use the example of Sandy, a young entrepreneur with a spouse and a few young children. Sandy has built a business whose value may approach the estate tax exemption; however, she has not accumulated significant liquidity or assets outside of the business. Moreover, let’s further assume this entrepreneur is the primary breadwinner in the family. She is concerned that, should she die unexpectedly, her spouse and children would not have access to funds to enable them to live comfortably. In this case, life insurance is an excellent vehicle to create immediate liquidity that would be available for the surviving spouse to provide for their family.

However, in the event of an immediate tragedy that affected both spouses, the benefit of the insurance – if owned by either of the deceased spouses – would be decimated by a 40% federal estate tax, plus any state inheritance or estate taxes. Alternatively, if that policy were held in an ILIT, the proceeds would be available to the surviving heirs without the 40% haircut of the estate tax.

Insurance to preserve an estate

The federal estate tax is imposed at 40% and is due nine months after an individual’s death. However, sometimes an individual’s estate is comprised primarily of an illiquid asset that cannot be easily liquidated, such as an operating business or real estate. In those cases, insurance may be used to help create a large cash position for a taxable estate that does not have sufficient liquidity to fund its estate tax liability.

For married couples, second-to-die insurance is typically the preferred vehicle due to its favorable premium-to-death-benefit ratio. In this example, a family has amassed a large estate that is primarily illiquid. The matriarch and patriarch purchase a second-to-die life insurance policy that will pay out on the death of the survivor. Once paid out, the life insurance proceeds can be used to satisfy the tax liability without requiring the estate to sell illiquid assets. And as in the example above, the problem with owning insurance in the estate is that it only increases the estate and the associated estate or inheritance tax.

The benefits of an ILIT

Whether insurance is purchased to create an estate or preserve an estate, an ILIT provides the most important benefit of keeping the proceeds of the life insurance from being included in the insured’s estate and losing any of those proceeds to unnecessary taxes. However, there are other benefits to an ILIT that accompany most irrevocable trusts, including:

• Protecting the assets of the trust from the creditors of the grantor and beneficiaries (including, for example, a divorcing spouse)

• Keeping assets out of a beneficiary’s estate so they may qualify for government benefits, if applicable

• Avoiding generation-skipping transfer tax, if structured appropriately (although many insurance trusts are not structured to be GST-exempt)

• Creating a cadence for distributions that is appropriate for the beneficiary pool and avoiding the risk of sudden wealth or poor planning by a beneficiary

The downside to an ILIT

Beyond the cost of setting up an ILIT and the additional nominal burden of properly funding and administering the trust, there are limited downsides to establishing an ILIT. A couple of relevant considerations follow:

Irrevocable trusts are, as their name suggests, irrevocable. However, with modern features that allow for certain flexibilities, the trust may be built to ensure that it continues to meet the needs of the settlors and grantors of the trust as well as the beneficiaries over time.

• In order for the insurance policy to not be included in the individual’s estate, the individual cannot retain ownership or control over the insurance policy. Therefore, an independent person should be named as trustee of the ILIT. However, given the relatively minimal burden of administering an ILIT, this should not be a particularly difficult role to fill.

• In order for the ILIT to pay the ongoing insurance premiums, the grantor will likely have to make additional gifts to the ILIT over time. These gifts typically require a minimal amount of additional paperwork to ensure that the gifts are made in a tax-efficient manner.

From an advisor’s perspective, one should always consider placing insurance in an ILIT when funding a life insurance policy and likely start with the question of “why shouldn’t I use an ILIT?” instead of asking why they should.

About Vanilla

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This article is for educational purposes only and should not be considered legal advice. If you feel that the information in this article is pertinent to your situation, you may wish to consult a qualified attorney for advice tailored to your circumstances.