An irrevocable life insurance trust is an estate planning tool that can help you reduce your taxable estate and avoid federal estate taxes.
How do ILITs work?
An irrevocable life insurance trust (ILIT) is a trust that is set up to own a life insurance policy on the life of the person who sets up the trust (the grantor). Once the trust is established, the grantor cannot make changes to the trust or access the policy’s cash value. This is why it’s called “irrevocable”.
The main purpose of setting up an ILIT is to remove the life insurance policy from the grantor’s estate for estate tax purposes. This can help reduce the amount of estate taxes that will be owed upon the grantor’s death. The policy’s death benefit is paid directly to the trust, which then distributes the proceeds to the trust’s beneficiaries.
To set up an ILIT, the grantor typically transfers ownership of the life insurance policy to the trust, which then becomes the policy’s owner and beneficiary. The grantor can make annual gifts to the trust to help pay the premiums on the policy. These gifts are subject to gift tax rules and may require the filing of a gift tax return.
The trustee of the ILIT is responsible for managing the policy and ensuring that the premiums are paid. The trustee can also make distributions to the trust’s beneficiaries, which are usually specified in the trust document. The beneficiaries typically receive the policy’s death benefit income-tax-free.
It’s important to note that once an ILIT is established, the grantor cannot make changes to the trust or access the policy’s cash value. This can be a disadvantage if the grantor’s financial situation changes and they need the funds. Therefore, it’s important to carefully consider the pros and cons of setting up an ILIT and to work with a qualified estate planning attorney to ensure that the trust is set up properly.
Tax Advantages of ILITs
One of the main benefits of an irrevocable life insurance trust (ILIT) is that it can help reduce the amount of estate taxes that will be owed upon the grantor’s death. When a person dies, their estate may be subject to federal estate taxes and/or state inheritance taxes, depending on the value of the estate and the state in which they live. These taxes can be quite substantial and can take a significant portion of an estate’s assets.
By transferring ownership of a life insurance policy to an ILIT, the policy’s death benefit is removed from the grantor’s estate for tax purposes. This means that the death benefit will not be subject to estate taxes when the grantor passes away. As a result, the beneficiaries of the ILIT will receive the policy’s death benefit income-tax-free, which can be a significant benefit for them.
In addition, if the grantor makes annual gifts to the ILIT to help pay the premiums on the policy, those gifts may be subject to gift tax rules. However, the gift tax rules provide an annual gift tax exclusion, which allows a person to give up to a certain amount (currently $17,000 per person in 2023) to an individual each year without incurring any gift tax liability. This means that the grantor can make gifts to the ILIT to help pay the premiums on the policy without incurring gift tax liability, as long as the gifts are within the annual exclusion amount.
Another potential tax benefit of an ILIT is that the trust can be structured as a “grantor trust,” which means that the grantor is treated as the owner of the trust for income tax purposes. This can allow the grantor to pay the income taxes on the trust’s income, which can help the trust’s assets grow more quickly over time.
It’s important to note that the tax benefits of an ILIT depend on the specific details of the trust and the grantor’s individual circumstances, and tax laws and regulations can change over time. Therefore, it’s important to work with a qualified estate planning attorney and tax advisor to ensure that an ILIT is set up properly and to understand the tax implications of the trust.
Upcoming Changes to the Gift Tax Limits
One reason that you may want to explore an irrevocable life insurance trust is that the estate tax limits could soon be cut in half.
Under current US federal estate tax law, the estate tax exemption amount is set at $12.92 million per person in 2023. This means that an individual can pass up to $12.92 million in assets to their heirs upon their death without incurring any federal estate tax liability. For married couples, the exemption amount is effectively doubled, as any unused portion of one spouse’s exemption can be transferred to the other spouse.
However, this exemption amount is scheduled to expire on December 31, 2025, which means that if no new legislation is passed by Congress, the exemption amount will revert back to pre-2018 levels. In 2017, the exemption amount was $5.49 million per person, adjusted for inflation, which means that the 2026 exemption amount is projected to be approximately $6 million per person.
It’s important to note that the expiration of the current estate tax limits is not automatic and can be changed by Congress. There have been proposals to lower the estate tax exemption amount or increase the estate tax rate, as well as proposals to eliminate the estate tax altogether. The outcome of the 2024 elections and the makeup of Congress may also have an impact on the future of the estate tax.
Controlling How Irrevocable Life Insurance Trust Benefits are Distributed
To control how ILIT benefits are distributed, the grantor can specify the terms of the trust in the trust document. The trust document can specify who the beneficiaries are, how much they are to receive, and when they are to receive their distributions. The grantor can also specify any conditions that the beneficiaries must meet in order to receive their distributions.
For example, the grantor can specify that the beneficiaries must reach a certain age or achieve certain milestones, such as graduating from college, before they can receive their distributions. The grantor can also specify that the trustee has discretion over when and how the distributions are made and can include provisions to ensure that the distributions are used for specific purposes, such as education or medical expenses.
It’s important to note that once an ILIT is established, the grantor cannot make changes to the trust or access the policy’s cash value. This means that it’s important to carefully consider the terms of the trust and to work with a qualified estate planning attorney to ensure that the trust is set up properly and that the terms of the trust align with the grantor’s wishes.
In addition, it’s important to communicate with the trustee and beneficiaries of the trust to ensure that everyone understands the terms of the trust and that there are no misunderstandings or disagreements. This can help prevent disputes and ensure that the ILIT operates smoothly and effectively to achieve the grantor’s intended goals.
Disadvantages of an Irrevocable Trust
While irrevocable life insurance trusts (ILITs) can offer several benefits, there are also some potential disadvantages to consider, including:
- Loss of control: Once an ILIT is established, the grantor cannot make changes to the trust or access the policy’s cash value. This means that the grantor gives up control over the policy and the trust assets.
- Complexity: Setting up an ILIT can be a complex process, and it may require the help of a qualified estate planning attorney. The trustee must also be knowledgeable about trust administration and compliance with tax laws.
- Cost: Setting up and maintaining an ILIT can involve significant costs, including legal fees, trustee fees, and premiums for the life insurance policy.
- Potential gift tax liability: If the grantor makes gifts to the ILIT to help pay the premiums on the policy, those gifts may be subject to gift tax rules. While there is an annual gift tax exclusion, larger gifts may be subject to gift tax liability.
- Inflexibility: The terms of the ILIT are set at the time the trust is established and cannot be changed. This means that the grantor must carefully consider the terms of the trust and ensure that they align with their wishes and goals.
- Potential loss of step-up in basis: If the ILIT is structured in a certain way, it may result in a loss of step-up in basis for the policy’s death benefit, which could result in higher capital gains taxes for the beneficiaries.
Talk to Your Advisor
Establishing an irrevocable life insurance trust (ILIT) can be a complex and important decision that requires careful consideration of the grantor’s financial, tax, and estate planning goals. For this reason, it’s important to work with a tax advisor and estate planning lawyer to decide if an ILIT is right for you.
A tax advisor can provide guidance on the potential tax implications of setting up an ILIT, including the gift tax, estate tax, and income tax consequences. They can also help you understand how an ILIT fits into your overall tax planning strategy and help you determine if it’s the right approach for your individual circumstances.
An estate planning lawyer can help you establish an ILIT that meets your specific needs and goals. They can provide guidance on the legal and regulatory requirements for setting up an ILIT and can help you structure the trust in a way that aligns with your wishes and helps achieve your estate planning objectives. They can also provide guidance on selecting a trustee and help you prepare the necessary legal documents to establish and maintain the trust.
Working with a tax advisor and estate planning lawyer can help ensure that your ILIT is set up properly and is aligned with your overall financial and estate planning goals. It can also help you avoid potential tax and legal pitfalls that could arise if the trust is not established correctly or does not meet your specific needs and goals.