Using an Irrevocable Life Insurance Trust (ILIT) to Reduce Estate Tax

Over the past few months in this space, we’ve been exploring possible changes to the estate tax under the Biden administration—and measures to minimize your tax burden. The discussion has included an alphabet soup of options including SLATs, DAPTs, GRATs and IDGTs. With this post, we’ll add a few more letters into the mix: ILIT which stands for “Irrevocable LIfe Insurance Trust.” If you have a high net worth with possible exposure to estate tax, you may want to learn more.

What is an ILIT?

An irrevocable life insurance trust, or ILIT, is an estate planning tool that prevents the benefits of a life insurance policy from being subject to the estate tax. If you are the owner and insured on a life insurance policy, the proceeds of your policy are included in your gross estate. A properly drafted ILIT can remove those proceeds from your estate.

As you know, if the estate you leave behind after death exceeds a certain amount (the lifetime exemption amount), the excess is subject to estate tax. Therefore, everything you are able to do during life to reduce the size of your taxable estate reduces the estate tax burden on the estate.

The amount of the lifetime exemption changes over time. It is currently $11.7 million dollars per person, but is scheduled to drop down to about half that in a few years. Depending on what the current administration does, the amount of the exemption could reduce even sooner. If you have a substantial life insurance policy, that could boost the size of your estate and increase the likelihood that estate tax will be due.

However, if an ILIT is the legal owner and beneficiary of the policy, the proceeds do not become a part of your estate. Therefore, the death benefit would not become subject to estate taxes. The policy is removed from your estate because the ILIT is irrevocable. Once you place the policy in the trust, you no longer have any control over it and cannot reclaim it. The trust is a “middle man” of sorts between the policy and the people you want it to benefit.

It is important for you personally to avoid “incidents of ownership” in the policy and for the irrevocable life insurance trust to be the undisputed owner of the policy. To this end, premiums for the life insurance policy should be paid by a bank account owned by the trust, not from your personal bank account.

Like any trust, an ILIT has a trustee and beneficiaries whom you (the trustmaker or grantor) designate. After your death, the death benefit of the insurance policy is paid to the trust, which is the named owner and beneficiary of the policy. The trustee of the irrevocable life insurance trust then manages the funds for the benefit of the beneficiaries of the ILIT. Depending on your instructions in the trust document, the trustee may invest the funds, or distribute them immediately to the beneficiaries. Beneficiaries may be your children or grandchildren, or anyone you choose.

Advantages and Disadvantages of ILITs

The primary advantage of an ILIT, of course, is that it makes it possible to transfer a large death benefit from a life insurance policy free of estate tax to your loved ones. Because the benefit goes into the trust, immature or imprudent beneficiaries cannot immediately get their hands on a large sum of cash. A trustee of your choosing will manage the proceeds of the life insurance policy as you direct.

One disadvantage of an ILIT is that it is irrevocable, meaning you cannot cancel or change the trust. While that is what makes it an effective tax planning tool, the irrevocable nature of the trust also makes it inflexible. Life, as we all know, is unpredictable, and while you may not feel the need to amend or revoke a trust now, you could later change your mind.

Another disadvantage is that irrevocable life insurance trusts are complex and can be costly to establish and maintain. That said, the costs are justified if the trust saves your estate from owing estate tax.

Is an ILIT Right for Your Needs?

If you have a large estate and a life insurance policy with a substantial death benefit, an ILIT might be a good choice for you. Not only would it keep the death benefit of the policy out of your gross estate, but it could provide liquid assets with which to pay debts of the estate, including any estate taxes owed. The trustee’s control over benefits that come into the trust can offer protection to beneficiaries. For instance, if one of the trust beneficiaries is disabled and receives means-tested government benefits, the trustee can ensure that they do not receive distributions that would make them ineligible for those benefits.

Unless your assets need to be protected from exposure to estate tax, though, an ILIT probably is not the best way to achieve your estate planning goals. If your estate is unlikely to be subject to estate tax, there are other estate planning tools that could achieve your aims more simply and cost-effectively. If you are unsure whether your estate will be at risk of exposure to estate tax liability, it is wisest to consult with an experienced estate planning attorney to discuss your situation. We invite you to contact Gudorf Law Group to learn more about tax planning strategies for your estate.