What Is An Irrevocable Life Insurance Trust (ILIT)?
An irrevocable life insurance trust (ILIT) is a financial tool that helps you take control of estate taxes and plan your legacy. ILITs aren’t for everyone. These financial tools come with nuanced pros and cons.
What Is an ILIT?
An irrevocable life insurance trust, or ILIT, is a financial tool used to manage life insurance policies and allocate benefits when you pass away. Once established, ILITs are irrevocable, which means they typically cannot be altered or terminated.
An ILIT involves three legal parties.
- Grantor: A grantor initiates and finances the trust and chooses a trustee to manage it.
- Trustee: The trustee pays the life insurance premiums, collects the death benefit when the grantor passes away and handles payouts to the beneficiaries.
- Beneficiaries: Grantors choose one or more beneficiaries to receive the ILIT’s life insurance policy benefits.
How Does an ILIT work?
An ILIT is a trust designed to hold life insurance. It exists separately from the grantor’s estate and is not included in the estate’s value. The trust is the owner and payor of the life insurance policy or policies in the trust rather than the policy owner.
Since the ILIT owns the life insurance, the grantor typically pays the trust, and the trustee uses these funds to pay the life insurance premiums. When the grantor passes away, the trustee collects the life insurance payout and handles payouts to the beneficiaries.
Pros of an Irrevocable Life Insurance Trust
Using an irrevocable life insurance trust can have tax advantages and can also give you more control over how the life insurance death benefit is used.
ILIT tax advantages
One advantage of an ILIT is that it can be used to pay estate taxes after the death of a high-net-worth individual. Most Americans (more than 99%) don’t end up owing estate taxes after someone dies—but heirs of estates valued at more than $12.06 million must pay an eye-popping 40% federal estate tax. That tax payment is typically due within nine months of a loved one’s death. Some states also impose their own estate taxes. Many states begin taxing estates at $1 million, so even if your estate isn’t valued at $12.06 million, an ILIT could help you with paying those taxes.
Since the value of the estate is often tied up in assets such as businesses or homes, families can have difficulty finding cash to pay estate taxes.
ILITs can help solve that liquidity problem. An ILIT’s trustee can purchase an estate’s assets. Those proceeds allow beneficiaries to pay estate taxes while still maintaining control of the estate’s assets.
Irrevocable life insurance trust benefits aren’t just for high-net-worth individuals.
ILIT legacy planning
In addition to tax benefits, ILITs may give you more control over how your death benefit is used. You can name multiple beneficiaries and direct how and when they are to use the money. If you were to name them as life insurance beneficiaries instead, they could spend the death benefit however they like.
Be aware that the federal government levies up to a 40% tax on individuals who transfer assets to persons more than two generations younger or more than 37.5 years younger than the person giving the gift.
Cons of an Irrevocable Life Insurance Trust
ILITs may help individuals with specific tax and legacy planning goals. However, ILITs can also come with the following risks. Consider these points before establishing an ILIT.
ILITs cannot be modified
“Once you assign your life insurance policy to an ILIT, you cannot reassign the policy to another trust or entity because you have waived all rights to your coverage,” says Mark Friedlander, spokesperson for the Insurance Information Institute.
Imagine a situation in which you set up an ILIT and name your spouse as a beneficiary, but years later you get divorced and want to remove them from the policy. “Unless specific language was added before executing the trust, there is not a simple fix to this situation,” says Hunter Gimbel, managing partner at Drucker Wealth.
ILITs may be taxable
If you die within three years of creating an ILIT, the trust’s life insurance policy may be included in your estate. If the life insurance payout is included in your estate, it could end up being subject to estate taxes along with your other assets.
You don’t own your life insurance policy
With an irrevocable life insurance trust, you do not own the life insurance policy, the trust owns it. Once you establish an ILIT, you typically cannot make changes to your life insurance policy. Your trustee oversees how the policy is managed and paid out, within the legal bounds of the trust.
How Do I Set Up an ILIT?
Irrevocable life insurance trusts are complicated legal entities and require expertise to set up. You should work with both an experienced lawyer and a financial advisor—and possibly other professionals—to properly set up the trust.
While ILITs can be beneficial, Gimbel warns that it’s important to fully understand the estate’s assets and the objective of the ILIT.
“The best way to do this effectively is to create a personal board of directors that includes a financial planner, insurance advisor, trust and estate attorney, and CPA that are all collaborating to ensure optimal planning,” he says