Irrevocable Life Insurance Trusts for Estate Planning

Estate planning is a critical component of financial security because it helps ensure a person’s assets are managed and distributed according to their wishes while minimizing their tax burdens. One of the most effective estate planning trust types is an irrevocable life insurance trust (ILIT). It is designed to hold and manage life insurance policies, offering significant tax advantages, asset protection and estate liquidity. However, as with any financial strategy, ILITs come with benefits and risks.

Key Takeaways

1. ILITs remove life insurance proceeds from the taxable estate, reducing potential estate taxes and ensuring more assets are transferred to beneficiaries.
2. Since ILITs are irrevocable, the grantor relinquishes ownership of the policy, safeguarding it from creditors and ensuring controlled distribution of proceeds.
3. ILITs require meticulous setup and administration and cannot be altered or revoked by the grantor once established, limiting their adaptability to changing circumstances.

Overview

An ILIT is a legal entity designed to own a life insurance policy. By acquiring a policy in an ILIT, individuals can exclude the policy’s death benefit from their taxable estate, potentially reducing estate taxes for their heirs.

How It Works

Establishing and maintaining an ILIT follows five specific steps.

• Create the trust: The grantor (the person establishing the trust) works with an estate planning attorney to draft a trust document that specifies the terms and beneficiaries.
• Acquire life insurance policy: The grantor either transfers an existing policy to the ILIT or directs the ILIT to purchase a new policy. If a policy is transferred to an ILIT, the grantor must survive the transfer by three years for the insurance proceeds to be excluded from their estate.
• Appoint a trustee: The grantor designates a trustee (an independent party or professional) to manage the ILIT and ensure compliance with legal and financial guidelines.
• Funding and premium payments: The grantor makes annual contributions to the trust, which the trustee then uses to pay the insurance premiums. To ensure tax compliance, beneficiaries typically receive Crummey notices, allowing them temporary rights to withdraw contributions before they are used for premium payments. A Crummey notice, or letter, is an official announcement to the beneficiary or beneficiaries that the trust has received a gift, and they may withdraw a certain amount in a specified time period.
• Distribution of proceeds: Upon the grantor’s passing, the life insurance proceeds are paid directly to the ILIT, which then distributes funds to beneficiaries according to the trust’s terms, free from estate taxes.

Benefits and Risks

Creating an ILIT can be a great way to reduce the tax burden on an estate, but establishing one comes with drawbacks that a potential grantor should consider.

Benefits

• Estate tax savings: Since the ILIT owns the life insurance policy, its proceeds do not contribute to the grantor’s taxable estate, potentially realizing potential tax savings.
• Creditor protection: Because the ILIT is a separate legal entity, creditors of the grantor generally cannot access the trust’s assets.
• Control over distributions: The grantor can establish specific terms dictating when and how beneficiaries receive funds, preventing reckless spending or mismanagement.
• Liquidity or estate expenses: The ILIT can provide liquidity to cover estate taxes, debts or other expenses, saving heirs from needing to sell off assets.

Risks

• Irrevocability: Once the ILIT is created and the life insurance policy is transferred, the grantor loses control and cannot alter the trust’s terms.
• Administrative complexity: ILITs require compliance with IRS regulations, including proper funding procedures, gift tax reporting and Crummey notices to beneficiaries.
• Gift tax considerations: Contributions to the ILIT may be subject to gift tax unless structured properly under the annual gift tax exclusion.
• Loss of direct access: The grantor cannot borrow against or change the policy after its transfer to the ILIT.

Use Cases

ILITs can be a strategic estate planning tool, especially for business owners, families with special needs dependents and blended families.

Regulatory Developments

Estate tax laws and regulations governing ILITs continue to evolve. Some key recent changes include:

• Increased state tax exemption: The federal estate tax exemption is historically high, reducing the necessity of ILITs for some individuals. However, this exemption is subject to legislative changes and may decrease.
• Regulatory scrutiny on grantor trusts: The IRS has increased oversight on trusts, including ILITs, highlighting the importance of compliance with transfer and reporting rules.
• Potential legislative proposals: There have been discussions on capping tax benefits related to estate planning tools like ILITs, which could impact their effectiveness in the future.

We’re Here to Remove the Guesswork

An ILIT remains a powerful option on your estate planning checklist, offering potential tax benefits, asset protection and control over wealth distribution. Careful consideration and professional guidance are always essential when weighing the benefits of a trust. With more than 65 years of experience helping families build comprehensive estate plans, Glenmede can help clients choose the right strategy for their unique situation.

For more information on ILITs, contact us here.

Frequently Asked Questions

Q: Which states have the highest estate taxes?

A: States with some of the highest estate taxes include Washington and Hawaii. Most states do not have estate taxes, but 17 states impose a combination of estate and/or inheritance taxes.

Q: Do beneficiaries of an estate pay taxes on inherited money?

A: Depending on how the estate is structured and in which state it’s sited, inherited money can be taxed on both a federal and state level, though there are a handful of mitigating factors such as tax exemptions.