What Is an Irrevocable Life Insurance Trust (ILIT)?

Irrevocable Life Insurance Trust

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The Use of an Irrevocable Life Insurance Trust to reduce tax liabilities.

Irrevocable Life Insurance Trusts, or ILITs, have long been a staple of estate planning, helping individuals, families, and business owners meet many goals. Notwithstanding, after the Tax Cuts and Jobs Act raised the federal estate tax exemption limits to $11.4 million per person and $22.8 million per couple, some people wondered whether an ILIT still made sense. Moreover, the logic goes that with more of your money now shielded from federal estate taxes, you may no longer need to worry about having to pay estate taxes on your insurance payouts. 

Attorney Steve Bliss with a document labeled irrevocable trust.

How Does an Irrevocable Life Insurance Trust Work? 

An irrevocable life insurance trust gives you additional control over your insurance policy and how the death benefit will be issued to your beneficiaries once you pass away. Since a life insurance policy is considered an investment and an asset, it will be included within your estate after your death. Accordingly, proceeds ‘the death benefit’ can be subject to an estate tax if your combined assets exceed the exemption limit set by the federal government.

According to Steve Bliss, Estate Planning and Trust Attorney at The Law Firm of Steven F. Bliss Esq., the answer isn’t as clear-cut as you might assume. To understand why let’s first look at how an ILIT works.

What is an irrevocable life insurance trust (ILIT)?

An ILIT (pronounced “eye-lit”) is trust-funded during your lifetime with one or more life insurance policies. It is irrevocable, which means that once you create an ILIT, the trust generally cannot be changed or revoked; the trust agreement terms are pretty much set in stone.

What are the benefits of an irrevocable life insurance trust (ILIT)?

In exchange for moving your life insurance policy into the trust, an ILIT provides certain advantages.

“For one, an ILIT can help you avoid having your policy death benefit included in your estate for federal estate tax purposes. At the same time, an ILIT gives you the ability to direct, through the trust document, how and when the death benefit is used, and for whom,” Elbert says.

Funding a trust with life insurance can also help provide the cash needed to cover estate taxes and other expenses after you die. That helps avoid selling a business or other high-value assets to cover those costs. Plus, “an ILIT enables you to fully leverage the annual gift tax exclusion — $15,000 per donee or beneficiary in 2019 – by using those gifts to pay the premiums on the life insurance in the trust”.

Does an irrevocable life insurance trust still make sense today?

So what role can ILITs play now, even with the current estate tax environment? Here’s what to consider if you weigh whether to open an ILIT.

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The current estate tax laws are set to revert

The new federal estate tax exemptions are temporary. Unless the laws are changed, these higher limits will sunset and revert to prior limits ($5 million for individuals and $10 million for couples, inflation-adjusted) beginning in 2026. Individuals with rapidly appreciating property or a growing business may want to consider “taking advantage of these higher limits by creating a new trust or adding to an existing one before the limits are halved.”

You may still have a state estate tax problem.

The federal estate tax isn’t the only concern for many affluent Americans; some states levy their separate estate tax. The life insurance death benefit within an ILIT can provide the funds to cover those taxes and other expenses.

ILITs protect beyond taxes.

An ILIT provides several advantages beyond providing a tax-free death benefit. This includes protecting your insurance benefits from divorce, creditors, and legal action against you and your beneficiaries. An ILIT also avoids probate and shields assets from expense and loss of privacy during probate.

“An ILIT can be used to protect an inheritance for a minor child, a loved one with special needs, or an adult child who lacks the maturity or financial savvy to handle a large sum of money,” Elbert says. “It can also provide liquidity to fund a business succession plan or to avoid having to sell an illiquid asset, such as a family business or a home. It can also help equalize inheritance among multiple beneficiaries.”

Minimizing estate taxes

Suppose you own a life insurance policy, and you pass away. In that case, the death benefit from the plan is considered an asset and thus is included within your aggregate estate. Consequently, if you were to place the life insurance within the ILIT, then the death benefit proceeds would not be included in your estate and would not become taxable.

In some cases, by not including your life insurance, you may be able to reduce your entire estate net worth below the federal exemption level and avoid the taxes altogether.

Of course, no one knows for sure what the future will bring for estate taxes and exemptions. Nonetheless, an ILIT can provide you, your loved ones, and your estate with significant benefits. To determine if an ILIT makes sense for your needs and goals and leverage the opportunities offered by the Tax Cuts and Jobs Act, it’s essential to review your estate plan with your financial and legal advisors and your tax professional today.

How does an estate tax work?

Your estate is all the money and property that you own. After you die, your estate will have to pay federal estate taxes if the total value exceeds the exempt amount allowed by law. For 2020, the estate tax exemption is $11.58 million. An individual can leave $11.58 million to any heirs and be completely exempt from paying estate taxes. Furthermore, if it is a married couple, the exemption would double $23.16 million.

Other irrevocable life insurance trust benefits

Life insurance trusts have many benefits outside of being used for estate tax purposes. These include but are not limited to:

Maximize control over proceeds: A trust will allow you, the insured, to give detailed instructions on using the death benefit. Typically, death benefit proceeds are given to the beneficiary either in a lump sum or over a specified payment schedule. With a Trust, you can provide added instructions. For example, you were holding back funds if the trust beneficiaries were too young or placing funds into different investment accounts to be used in the future.

Provide income to spouse: By putting the life insurance policy into a trust, the death benefit can provide income to your spouse without increasing your spouse’s estate.

Prevent outside the control of the life insurance: In typical life insurance scenarios, if the beneficiary becomes incapacitated, ill, or dies, the insurance proceeds would then get transferred directly to your estate. Notwithstanding, by placing the life insurance within the trust, this scenario would not happen.

How to set up a trust

Setting up a trust properly can be a confusing process. Nevertheless, we recommend reaching out to a creditable Trust Attorney who is passionate about Irrevocable Life Insurance Trusts.