Irrevocable Life Insurance Trusts (ILIT)


Irrevocable Life Insurance Trusts (ILIT)

What is an ILIT?

An ILIT is an estate planning wealth management tool that is specifically drafted to own a life insurance policy or policies.  The ILIT is irrevocable and once set up, cannot be changed.  Designed to reduce estate tax while creating the ability to pass on the insurance proceeds to heirs and beneficiaries.

What is the Purpose of an Irrevocable Life Insurance Trust?

The main purpose of an irrevocable life insurance trust is to eliminate estate taxes by moving or purchasing life insurance in the name of the ILIT and thus avoid federal income tax. Drafted properly, your family members will receive all the life insurance proceeds, without diminishing the proceeds with an estate tax.

Are Irrevocable Life Insurance Trusts Taxable?

An irrevocable life insurance trust (ILIT) is designed to hold insurance policies. The buildup of cash value inside the policy owned by the trustee of the ILIT is wholly free from income tax.  Moreover, the life insurance proceeds received the by heirs of the ILIT are not subject to federal income tax.

What is an Irrevocable Life Insurance Trust (ILIT)? 

An Irrevocable Life Insurance Trust (ILIT) is a non-amendable irrevocable living trust, meaning once it is set up, it is no longer part of your estate and cannot be changed. It holds one or more life insurance policies. It is a financial planning and estate planning tool that used properly can save in estate taxes. You have given full control to the Trustee, yet you do have the right to change the Trustee at any time! 

The Trust is also the beneficiary of the policy. Properly drawn, ILIT’s provides several benefits but also has its disadvantages.

Read on.

When Should I use an Irrevocable Trust?

The main objective of an ILIT is to reduce or eliminate estate taxes. An ILIT excludes the death benefit from the estate of the insured. 

Take note; if the decedent owns the insurance policy, the death benefits will be in his/her estate and can be subject to a 40% tax rate. Therefore, it’s a great wealth management strategy.

What Parties are Part of an ILIT?

 There are several parties to the ILIT. The parties are the following:

  • Grantor (trust-maker): Is the person(s) creating the ILIT. Grantor makes the rules on how the Trust makes the distributions to the heirs. You will “gift” a check payable to the ILIT trustee to enable payment for the policy premium.
  • Trustee: Administers of the Trust. Note: the grantor should not be the Trustee to retain the full tax benefits.
  • Beneficiary: When you purchase the life insurance policy, you’ll designate who gets the death benefits — the life insurance beneficiary.

The owner of the insurance policy is the ILIT and no longer part of your estate. The ILIT owns and controls a term or permanent life insurance policy or policies while the grantor is alive. The Trust makes the premium payments, not the grantor.

What are a few of the duties of the ILIT Trustee?

Some of the duties of the Trustee include the following:

  • To open and manage a trust checking account
  • To obtain a Federal taxpayer identification number (TIN) for the (ILIT) trust entity, if applicable. Getting the TIN will allow the Trustee to apply for new life insurance policies, transfer existing policies, open accounts.
  • Purchase Life Insurance Policies on the grantor (insured)
  • Ability to accept funds from the grantor. The grantor to pay via a “gift” payable to the ILIT trustee. Immediately deposit the premium check-in the ILIT’s checking account.
  • Regarding Crummey, send Crummey withdrawal notices
  • Pay the premiums to the life insurance company(s)
  • The ability to make investment decisions
  • If needed, file tax returns
  • At your death, claim insurance proceeds
  • Keep the fiduciary duties of the Trustee, i.e., maintain all records of trust activity, 
  • Keep premium notices (documents). Send to grantor and Trustee
  • Complete the wishes of the grantor.

What is the correct alternative to funding the ILIT?

When you are ready to fund the Trust, consider something called the Crummey powers to your advantage. The Crummey trust provisions have terms of within the Trust wherein the grantor can claim the annual gift tax exclusion for monies placed in the Trust. 

How do I fund the ILIT?

When you are ready to fund your ILIT, there are one of two ways:

  1. Transfer Your Existing Policy: You may transfer an insurance policy. Now, an existing policy can either be gifted or sold to an ILIT. There are some complications, however, if you assign a policy to the ILIT. (See the disadvantage of an ILIT section – three-year rule)
  2. Have the Trust purchase it directly. By the Trust purchasing the policy, it will avoid the three-year rule. The Trustee can buy a life insurance policy. The Trustee signs all the ownership of the policy, including the initial application for the policy. You will want to designate the ILIT as the original owner and beneficiary of the insurance policy. 

What kind of Insurance policies can an ILIT hold?

An ILIT can own the following:

  • There are many types of permanent life insurance policies.
  • Second to die life insurance policies. Other names: dual-life insurance, survivorship insurance. If you are married, you can use this type of policy, which pays out a death benefit once both spouses have passed away.
  • The final and most important step in completing your ILIT. Coordination with your insurance agent and your estate planning attorney is important before funding the policy.  Insurance companies will not fund the policy until the ILIT is in place.

We have been working with insurance agents and insurance companies throughout the country.  We will be happy to work with your current insurance agent and assist your family in setting up your ILIT.

How does an Irrevocable Life Insurance Trust (ILIT) work?

When the grantor dies, the proceeds of the insurance policy stays inside the Trust, thus keeping proceeds out of the taxable estate. The Trustee will complete their fiduciary duty to complete the grantor’s wishes. 

What are the Advantages of an ILIT?

There are several advantages to an ILIT. Here are some examples:

  • Reduces estate tax liability
  • It can include a spend-thrift provision. It will pay your heirs a monthly payment instead of a large lump sum upfront. Useful if a beneficiary does not handle finances appropriately. 
  • You can change the Trustee and any time.
  • Your ILIT is kept private. 
  • An ILIT offers asset protection and protects the insurance proceeds from creditors.
  • Money in the irrevocable life insurance trust has liquidity. It can be turned into cash quickly.
  • An ILIT can protect a beneficiary who is receiving government aid, such as SSDI (social security disability income) or Medicaid.

What are the disadvantages of an ILIT?

The disadvantages of an ILIT are the following:

  1.  A complex tax planning method. Strict compliance with regulatory requirements and legal requirements.
  2. An ILIT is an irrevocable Trust, meaning it cannot be changed. 
  3. The IRS will not allow you to avoid estate taxes and control your life insurance policy.
  4. Once you assign your policy to an ILIT, you cannot reassign the policy to another trust or entity.
  5. If the ILIT does not own your life insurance for at least three years before your death, the IRS will not honor your ILIT. (Incident of ownership). Therefore if you transfer an existing life insurance policy to the ILIT, there is a 3-year lookback period. You may want to consider an “estate protection rider,” which can protect your heirs from a hefty estate tax should you pass away within the three years. It offers extra financial support to cover taxes in this scenario. Lastly, should you feel compelled to shield yourself from uncertainty, sell your policy to the Trust for its fair market value. By selling the policy, you avoid the 3-year rule.
  6. If you transfer an insurance policy, and you die within the 3-year lookback AND has a substantial accumulated cash value, there may be a gifting problem. Therefore a properly drafted ILIT can keep your estate out of trust litigation

Why Hess-Verdon & Associates

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Jillyn Hess-Verdon

Jillyn Hess-Verdon

Managing Partner

R. Kurt Ketchum

R. Kurt Ketchum

Associate Attorney

David Crumpton

David Crumpton

Associate Attorney

Stacy L. Olsen

stacy l. Olsen

Associate Attorney