An irrevocable life insurance trust (ILIT) is a crucial tool in estate planning, primarily utilized for its permanence once established. Unlike a revocable trust, which allows modifications or cancellations by the grantor, an ILIT cannot be amended after creation.
Fundamentally, an ILIT is funded with one or multiple life insurance policies, the critical being its irrevocability. This means the grantor forfeits the ability to alter or dissolve the trust once it is set up. This contrasts with cable trust, where such adjustments are permissible.
In the context of estate planning, an ILIT involves three main parties: the grantor, who initiates the trust; the trustee, responsible for managing the trust’s affairs, including the payment of life insurance premiums; and the beneficiaries, who will ultimately receive the trust’s assets upon the grantor’s death.
Establishing an ILIT segregates the trust’s asset value from the taxable estate’s value. The life insurance death benefit is directed straight into the trust upon the grantor’s death. The trustee then disburses these assets to the beneficiaries per the directives outlined in the trust document.
There are two principal types of ILITs:
- Funded ILITs: These trusts own income-generating assets, using the generated income to cover life insurance premiums.
- Unfunded ILITs: The sole asset typically is the life insurance policy itself in these trusts. The grantor makes regular contributions to the trust, which the trustee uses to pay premiums.
Establishing an ILIT hinges on several factors relevant to estate planning.
Planning for Estate Taxes
Federal estate taxes are not a significant concern for many individuals due to the generous exemption of $13.61 million per individual in 2024. However, some states impose estate taxes on smaller estates. Establishing an Irrevocable Life Insurance Trust (ILIT) could be a strategic solution if estate taxes concern you.
By funding an ILIT, you can ensure liquidity to cover estate taxes and other final expenses. Moreover, transferring a life insurance policy into a properly structured ILIT at least three years before your death can exclude the policy’s death benefit from your gross estate, potentially reducing estate tax liability.
Seeking Creditor Protection
An Irrevocable Life Insurance Trust (ILIT) offers robust creditor protection both during your lifetime and after your passing. Upon death, the assets held within an ILIT are generally inaccessible to creditors. Furthermore, creditors of your beneficiaries cannot compel distributions from the ILIT. Additionally, the trustee can utilize ILIT assets to directly cover expenses for your beneficiaries, safeguarding the funds from seizure by creditors during distribution.
Caring for a Loved One with a Disability
ILITs are commonly utilized in special-needs planning to safeguard a loved one’s eligibility for government benefits based on financial need, such as Medicaid.
Setting up an ILIT
An irrevocable life insurance trust is a complex estate-planning tool. If you think it may be appropriate for your needs, working with an experienced estate planning attorney is essential. If the trust is not administered correctly, the life insurance proceeds could revert to the estate.
If you are a trustee, it’s essential to understand you are now a fiduciary with a legal duty to act in the best interest of the trust’s beneficiaries.
Pros and Cons of an Irrevocable Life Insurance Trust
Benefits of an Irrevocable Life Insurance Trust (ILIT)
An ILIT offers several advantages when you transfer your life insurance policy into the trust. According to Johnston, “Firstly, an ILIT can exclude your policy’s death benefit from your estate for federal estate tax purposes. Simultaneously, the trust document powers you to specify how and when the death benefit is utilized and for whom.”
Furthermore, funding a trust with life insurance can provide the necessary liquidity to cover estate taxes and other expenses after your death, thus avoiding liquidating high-value assets like businesses. Johnston adds, “An ILIT allows you to maximize the annual gift tax exclusion—$18,000 per donee or beneficiary in 2024—by utilizing these gifts to pay the premiums on the trust’s life insurance.”
Downsides of an Irrevocable Life Insurance Trust (ILIT)
However, there are considerations to bear in mind when opting for an ILIT. One significant aspect is that establishing such a trust requires relinquishing all control over its assets, including decisions regarding beneficiaries and the conditions under which they receive the assets.
“Life insurance is highly flexible,” Johnston notes. “As the policy owner, you typically can withdraw funds, often tax-free, through partial surrenders or loans. The primary trade-off in establishing an ILIT is losing personal control over the policy. What was once your personally owned asset, available for personal and retirement needs, becomes a trust-owned asset primarily allocated for legacy purposes.”
Additionally, the costs associated with setting up and maintaining an ILIT can be a concern, involving professional fees and the obligation to file gift tax returns when funding the trust initially and possibly in subsequent years.
Understanding an ILIT (Irrevocable Life Insurance Trust)
An Irrevocable Life Insurance Trust, or ILIT, is a strategic financial instrument for managing life insurance policies and distributing benefits upon the grantor’s death. Once established, ILITs are typically immutable, meaning they cannot be altered or revoked.
An ILIT involves three primary legal entities:
- Grantor: The initiator of the trust who funds it and appoints a trustee to oversee its administration.
- Trustee: This person is responsible for paying life insurance premiums, collecting the policy’s death benefit upon the grantor’s demise, and distributing the proceeds to the beneficiaries.
- Beneficiaries: Individuals the grantor chooses to receive the life insurance benefits held within the ILIT.
How Does an ILIT Operate?
An ILIT functions as a separate entity from the grantor’s estate, with its life insurance policies excluded from the estate’s total value. The ILIT assumes ownership and payment responsibilities for the life insurance policies rather than the grantor retaining ownership.
Typically, the grantor contributes funds to the ILIT, which the trustee then utilizes to pay the life insurance premiums. Upon the grantor’s death, the trustee manages the collection of the life insurance payout and subsequent disbursements to the designated beneficiaries.
What is an ILIT (Irrevocable Life Insurance Trust)?
To grasp the concept of an Irrevocable Life Insurance Trust (ILIT), it’s essential to understand the broader concept of trusts. Trusts are fiduciary arrangements where one party (the trustee) holds assets for the benefit of another party.
Simply put, a trust involves transferring assets to a trustee, who manages them and eventually distributes them to your chosen beneficiaries. Trusts can hold various valuable assets, such as cash, real estate, and other forms of property.
Frequently Asked Question
What is an ILIT?
An ILIT, short for Irrevocable Life Insurance Trust, is a legal entity that holds life insurance policies. It’s structured to manage and distribute the proceeds from these policies upon the death of the insured individual.
How does an ILIT work?
Once established, an ILIT owns the life insurance policies, not the insured person. The insured individual typically funds the trust to pay premiums. Upon the insured person’s death, the trust receives the insurance proceeds, which are then managed and distributed by a trustee to the beneficiaries as specified in the trust document.
Why would someone consider setting up an ILIT?
People often establish ILITs to exclude life insurance proceeds from their taxable estate, potentially reducing estate taxes. Additionally, ILITs can control how and when beneficiaries receive insurance benefits, protecting those benefits from creditors.
What are the key parties in an ILIT?
- Grantor: The person who establishes and funds the trust.
- Trustee: Manages the trust, including paying premiums and distributing proceeds.
- Beneficiaries: Individuals or entities designated to receive the life insurance proceeds.
What are the drawbacks of an ILIT?
One primary consideration is that an ILIT is irrevocable, meaning it cannot be changed once established. This loss of control over the assets can be a significant trade-off. Additionally, setting up and maintaining an ILIT may involve professional fees and administrative responsibilities.
Conclusion
An Irrevocable Life Insurance Trust (ILIT) is a structured legal arrangement designed to manage life insurance policies outside an individual’s estate. By transferring ownership of the policies to the trust, the insured person can potentially reduce estate taxes and maintain control over how insurance proceeds are distributed to beneficiaries. While setting up an ILIT involves relinquishing control over the assets, the benefits of estate tax savings and creditor protection often outweigh the drawbacks for many individuals engaged in comprehensive estate planning.