Insights

Irrevocable Life Insurance Trusts (ILITs): Making Your Insurance 100% Tax Free

04.12.24

Life insurance can provide a tremendous financial benefit to the beneficiaries of a policy – with no income tax liability for the payout of life insurance proceeds. However, many people do not realize that the face value of the death benefit is included in the calculation of federal estate tax liability. That is where an Irrevocable Life Insurance Trust (ILIT) can help.

The ILIT is an estate planning tool designed to reduce or even eliminate payment of federal estate tax upon death.

The federal estate tax exemption stands at $13.61M per individual for 2024. However, the legislation that created this large exemption is set to expire on December 31, 2025, with the exemption being cut in half. If your assets are in jeopardy of being subject to estate tax upon death, the use of an ILIT (or multiple ILITs) may be vital to your estate plan.

What is an Irrevocable Life Insurance Trust?

An Irrevocable Life Insurance Trust (ILIT) is a type of trust that is specifically set up to own a life insurance policy. Once you transfer a life insurance policy into an ILIT, you give up all rights to the policy – the trust becomes the owner and the beneficiary of the policy. As the name implies, this type of trust is irrevocable, meaning that once it is created, it cannot be altered or canceled.

Key Benefits of ILITs

Avoid Estate Tax. Since the ILIT is the owner of the life insurance policy, the death benefits from the policy will not be part of the grantor’s taxable estate and therefore will not be subject to federal estate tax upon the grantor’s death.

Convert Old Policies. Ownership of current life insurance policies can be transferred to an ILIT. This allows a grantor to convert an asset that may be subject to federal estate tax into an asset that will not be subject to federal estate tax.

Avoid Gift Tax. If the ILIT is drafted and administered properly, the money used to pay policy premiums can qualify for the federal gift tax annual exclusion.

Dynasty Planning. ILITs can also leverage a grantor’s generation skipping transfer (GST) tax exemption. As a result, numerous generations may benefit from trust assets free of both federal estate and GST tax.

Asset Protection. With proper drafting, assets left in an irrevocable trust for beneficiaries can be protected from their creditors.

How Does an ILIT Work?

To set up an ILIT, an irrevocable trust agreement must be created and executed, and a trustee appointed who will manage the trust. The ILIT then applies for and owns the life insurance policy on the life of the grantor. The grantor cannot serve as the trustee of the ILIT.

The trust’s terms will dictate how the proceeds of the insurance policy are to be distributed upon the grantor’s death. Grantors can fund the trust with annual gifts, which are used by the trustee to pay the insurance policy premiums. Specific procedures may be required to ensure these gifts qualify for the annual gift tax exclusion.

Considerations When Setting Up an ILIT

  • Permanence: Since the ILIT is irrevocable, grantors need to be certain in their decisions because once established, it cannot be easily changed.
  • 3-Year Rule: If an existing policy owned by a grantor is transferred to an ILIT and the insured dies within three (3) years from the date of the transfer, the life insurance proceeds will be included in the grantor’s taxable estate.
  • Gift Tax Issues: The transfer of a life insurance policy into an ILIT will be considered a gift of the fair market value (approximately the cash surrender value) of the policy, and if that value is more than the annual exclusion, the Grantor’s federal estate tax exemption will be reduced by that amount.

Due to the complexities involved, it’s important to consult with legal and tax professionals before establishing an ILIT. Implementing an Irrevocable Life Insurance Trust as part of your estate plan can be an effective way to minimize taxes, protect assets, and ensure that the proceeds from a life insurance policy are used according to specific wishes. Work with an MAI advisor to find out if an ILIT is right for you.

Information updated as of March 26, 2024. This is for educational purposes only.  The opinions and analyses expressed herein are subject to change at any time. Any suggestions contained herein are general, and do not take into account an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Distribution hereof does not constitute legal, tax, accounting, investment, or other professional advice. Recipients should consult their professional advisors prior to acting on the information set forth herein. In accordance with certain Treasury Regulations, we inform you that any federal tax conclusions set forth in this communication, were not intended or written to be used, and cannot be used by any taxpayer, for the purposes of avoiding penalties that may be imposed by the Internal Revenue Service.

We look forward to learning about your financial goals.

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