An irrevocable life insurance trust (ILIT) is a common part of many estate plans, offering a way to pass on property and assets in a tax-efficient manner when you die. When assets, including life insurance policies, are transferred into an irrevocable trust, they are removed from your taxable estate. However, this also means that you give up control and rights to those assets.
Trusts may seem complicated, but in this guide, we’ll break down how they work and why they might be beneficial. This information will help you understand trusts better and determine if you need one.
Table of Contents
- What Is a Trust?
- What Is an Irrevocable Life Insurance Trust?
- Are There Downsides to an ILIT?
- How to Set Up an Irrevocable Life Insurance Trust
Unsure if you need a will, trust, or both? Learn what makes them different and how to determine if you need one in our guide: The Difference Between a Will and a Trust.
What is a trust?
Before jumping too far into what an ILIT is, let’s first review what a trust is.
A trust is a fiduciary arrangement that allows a third party to hold and manage assets or property for chosen beneficiaries. A trust allows you to outline precise instructions for the distribution of these assets, specifying factors like who receives them and when.
|Note: A fiduciary is a person or entity that holds a legal relationship of trust with one or more other parties. When responsible for managing assets, they must act in the best interests of those they represent, adhering to a duty of loyalty and care, and maintaining transparency and honesty in all dealings.
- Grantor: This person creates the trust and transfers their property to the care of a trusted fiduciary, the trustee.
- Trustee: The person or organization that acts as a custodian for the assets held in a trust. They are responsible for managing and distributing assets according to the instructions set by the grantor in the trust document.
- Beneficiary: This person(s) benefits from the trust in some way.
- Property: Almost anything of legal ownership, real estate, bank accounts, stocks and bonds, jewelry, life insurance policies, etc. can be transferred to and held in a trust. Also called the trust corpus or principal.
- Terms: Trust terms, or powers, establish the responsibilities and duties of the trustee. It also includes distribution instructions, any clauses or provisions, and appointments for a successor trustee if the present trustee is unable or unwilling to perform their duties.
Primary Types of Trusts
There are many types of trusts, each performing a variety of functions.
The three overarching types of trusts include:
- Living Trust: Created while you are alive, a living trust enables you to manage your assets during your lifetime. It provides details on how the assets should be distributed after your death.
- Testamentary Trust: Created through your will, this trust only comes into effect after your death. It outlines how assets will be managed and distributed for the benefit of specific individuals or purposes.
- Charitable Trust: This type of trust holds and manages assets specifically for the benefit of a charity. This trust can have many tax incentives and financial benefits for the grantor.
A trust can be established as revocable or irrevocable.
- Revocable Trust: A revocable trust allows the grantor to keep control over the assets within the trust while alive. Assets can be transferred or revoked at any time during the lifetime of the grantor. Although assets in a revocable trust avoid probate, they are still subject to estate taxes.
- Irrevocable Trust: Once assets are placed into an irrevocable trust, the grantor loses control over them and cannot terminate the trust or reclaim the property. Assets within an irrevocable trust bypass both probate and certain taxation.
What is an ILIT and why put life insurance in it?
An irrevocable life insurance trust (ILIT) is a specific type of living trust, irrevocable in nature, and often used for strategic estate planning. It’s created to hold term or permanent life insurance policies while the insured is alive.
The ILIT is the owner, payor, and beneficiary of the life insurance policy.
You, the grantor, fund the trust and the trustee uses this money to pay the life insurance premiums. Upon your death, the life insurance policy death benefits are paid to the trust and the trustee manages and distributes the payouts to your beneficiaries according to the terms you set in the trust.
Here are the primary reasons you might consider creating an ILIT:
- Estate Tax Reduction: Keep life insurance proceeds out of taxable estate to lower estate taxes.
- Asset Protection: Shield policy value from creditors and legal claims.
- Controlled Distribution: Determine how and when beneficiaries receive proceeds.
- Charitable Giving: Include provisions for directing funds to charitable causes.
- Avoid Probate: Simplify asset transfer by bypassing probate.
- Preserve Privacy: Maintain financial privacy as trust terms remain private.
- Provide Liquidity: Offer funds for estate settlement costs without selling assets.
- Support for Blended Families: Establish clear instructions on distributing insurance benefits (and other assets) among children from different relationships.
- Special Needs Provision: Provide financial support while protecting the needs-based government benefits of loved ones with special needs.
- Tax Efficiency: Minimize estate, income, gift, and generation-skipping transfer taxes for both the grantor’s estate and beneficiaries.
- Long-Term Planning: Structured approach to wealth preservation and legacy planning.
By placing your life insurance in an ILIT, you ensure that the policy’s benefits align with your specific wishes, financial goals, and family dynamics. It offers a controlled and protective way to manage the insurance proceeds, particularly valuable if beneficiaries may struggle with managing large sums or if there are complex family relationships involved.
Are there downsides to an ILIT?
The main disadvantages of putting property into an ILIT, or any irrevocable trust, include:
- Losing Control Over Assets: Once assets are placed in an ILIT, you lose control over them. For permanent life insurance policies with cash value, this loss of control includes not being able to access that cash value.
- Inflexibility: Once established, an ILIT’s terms generally can’t be changed.
- Costs and Complexity: Establishing an ILIT can be a time-consuming process that may require legal and professional guidance due to its complexity. The associated legal fees and consultation costs can add to the overall expenses of creating the trust.
It’s important to note that, in some cases, an irrevocable trust can be dissolved by the court.
See what you’d pay for life insurance
How to Set Up an Irrevocable Life Insurance Trust
When creating an ILIT, there are important steps to consider to ensure the life insurance proceeds are kept out of your taxable estate.
- Ownership Arrangement: If you want to keep a life insurance policy out of your estate, someone other than you must own the life insurance policy. You can create an ILIT, where the trust itself owns the policy.
- Creating the ILIT: With the help of an attorney, create a life insurance trust. Apply for life insurance as you normally would, and then work with your agent or broker to ensure the trust is named owner when the policy is issued. Any death benefits from the policy are paid to the trust.
- Transferring Existing Policies: If you have a life insurance policy already, you can move it to an ILIT to keep it out of your estate. You must give up all ownership rights to the policy due to the irrevocable nature of the trust. Additionally, the transfer must happen more than three years before your death to satisfy the Three-Year Look-Back Rule; otherwise, it may still be considered part of your estate for tax purposes.
- Annual Gifting Strategy: One way to pay for life insurance premiums is through annual noncharitable gifts contributed to the trust. The annual gift tax exclusion limit determines this amount (currently $17,000 per recipient for individuals and $34,000 for married couples). If the ongoing premiums exceed the annual gift tax exclusion, donors may use their lifetime gift tax exemption amount.
- Gift of a Present Interest: To ensure the gifts meet the annual gift tax exclusion criteria, trust beneficiaries must be given immediate access to the funds. The goal is to provide beneficiaries these rights, known as Crummey powers, but inform them not to take the money so it can fund the trust.
- Reducing the Estate: By making non-charitable gifts to pay premiums, you can effectively reduce your federal gross estate by the gifted amount. Over time, this reduction can have a positive impact on estate taxes.
Learn more about life insurance taxation in our guide.
Applying for Life Insurance for an ILIT
We’re not strangers to the complexity of life insurance and trusts. If you need to get life insurance in place for financial and estate planning purposes, we can help.
Life insurance is one of the best tools to provide financial protection for those you love most. The death benefits are typically tax-free and bypass probate, getting to your beneficiaries sooner.
Get instant life insurance quotes today—no contact information required. When you’re ready to take the next step, the online application only takes a few minutes. Once you apply, a dedicated Quotacy agent will be there for you, answering any questions and ensuring a smooth process from start to finish.
If your estate needs are particularly complex, we do recommend working with an experienced estate planning attorney or a certified financial planner (CFP) who specializes in estate planning.
This article is for educational purposes and not written by a financial advisor.