What Is an Irrevocable Life Insurance Trust (ILIT)?
An Irrevocable Life Insurance Trust, or “ILIT” is an irrevocable trust that own life insurance.
Historically, Americans have used ILITs as a vehicle to make gifts to beneficiaries that take advantage of the annual gift tax exclusion, and to protect proceeds of the policy from the estate tax.
If you own a life insurance policy when you die, it counts as part of your gross estate for federal estate tax purposes. However, if an ILIT owns the policy, the proceeds of the policy will pass outside of your estate to the beneficiaries of the ILIT, which can be your spouse, or your children, or anyone really.
What is the Estate Tax?
The federal estate tax is a tax the federal government levies on the property a deceased person transfers to his heirs. Some states have state estate taxes. Texas does not.
However, just because the federal estate tax exists does not mean that every estate is subject to it. In fact, Congress has effectively repealed this tax for 99.8 percent of the population.
Although every citizen is subject to the estate tax, a certain amount of a deceased person’s estate is exempt from taxation. In 2023, under the Tax Cut and Jobs Act, an individual can transfer $12.92 million to heirs without any federal estate tax liability. This amount is indexed for inflation and increases incrementally every year. The federal estate tax is due only for property that exceeds the exempt amount.
Note, however, that estate tax laws brought about by Tax Cut and Job’s Act will expire after 2025. Starting in 2026, the exemption amount will be cut in half. There is also the possibility new legislation will change the excluded amount before it expires, reducing the amount that is exempt from estate tax.
How Do I Figure Out the Value of my Estate?
You can calculate the value of your taxable estate for estate tax purposes by subtracting your debts and liabilities from your gross estate.
Your gross estate includes all the property you own, such as real estate, vehicles, business interests, bank accounts, brokerage accounts, retirement accounts, personal property, money owed to you at the time of death, and death benefits from your life insurance policies.
Liabilities include all your debts and expenses, such as mortgages, lines of credit, personal loans, credit card debt, funeral expenses, charitable gifts, expenses associated with the administration of your estate, certain medical expenses, and transfers to a spouse who is a citizen of the United States.
If the value of your net estate is greater than the federal estate tax exemption, your estate will owe federal estate tax.
How does an ILIT Help Avoid Estate Tax?
Life insurance death benefits are generally exempt from income tax; however, they do count as part of your gross estate. An ILIT can help estates avoid estate tax by removing the policy from your gross estate.
The ILIT can purchase a new insurance policy. It is also possible to transfer an existing policy to the ILIT. Note, however, if you transfer the policy, you must survive for at least three years after the transfer date in order for the policy to not count as part of your gross estate. The purpose of this rule is to prevent individuals from gifting their assets to their heirs when they learn death is imminent to avoid estate taxes.
If the ILIT purchases the policy, or if you transferred it to the ILIT more than three years before your death, the death benefits will escape estate tax. So, for example, suppose you are a single person with a $10 million dollar estate, and have a $5 million life insurance policy. Without an ILIT, your federal estate tax liability could be close to $1.4 million; however, if the ILIT owned the policy, the estate tax due would be $0.
Several financial institutions have estate tax calculators, such as this one by Merrill Edge, which you can use to estimate your estate tax liability.
How Does an ILIT Work?
An ILIT is a complex estate planning tool. It is always best to seek out competent legal and tax advice from qualified professionals who can draft the trust agreement and advise you on how to administer the trust in a way that helps preserve your annual gift tax exclusion and ensure the death benefits will not be part of your gross estate.
Drafted property, an ILIT will serve as both the owner and the beneficiary of an insurance policy. The policy insures the life of the person creating the ILIT, known as the grantor. During the grantor’s life, a trustee, who must be someone other than the grantor, will pay the premiums of the policy from money the grantor transfers to the trust.
Money contributed to the ILIT to pay the premiums will qualify for the annual gift tax exclusion if the trust gives the beneficiaries Crummey powers. It is also possible to transfer a large lump sum to the ILIT upfront, which the trustee can use to pay future premiums.
If the trustee administers the trust properly, death benefits distributed to the ILIT after the grantor’s death will not be included in the grantor’s gross estate. The death benefits may also provide some liquidity to the estate for payment of estate taxes and debts.
Pitfalls of ILITs
If you’ve gone through the effort and expense of creating an ILIT, it’s important to administer properly in order to reap its benefits.
If the ILIT is a Crummey trust, it is important to observe all formalities to preserve your annual gift tax exclusions. Also, to exclude policy proceeds from your gross estate, it is extremely important you part with all “incidents of ownership” in the policy.
“Incidents of ownership” encompasses all the rights to control or derive an economic benefit from the policy, such as the power to change a beneficiary, to surrender or cancel the policy, to assign the policy, to pledge the policy for a loan, or to borrow against its cash value. Retaining these rights will cause the grantor to be deemed the owner of the policy. As a result, the proceeds of the policy will be counted as part of the grantor’s gross estate.
Texas is a community property state. There is a presumption that property you acquire during your marriage is community property. If you’ve named your spouse as a beneficiary of the ILIT, it’s crucial that your spouse not make any contributions to it. Otherwise, half the ILIT may be included in your spouse’s estate. To avoid this result, you should only transfer separate property to the trust. You can accomplish this by executing a partition agreement. A partition agreement will allow you to divide community property into equal shares of separate property, which you can then use to contribute to the ILIT.
Disadvantages of ILIT?
As the name suggests, an irrevocable life insurance trust is irrevocable. You cannot amend the trust after you create it. This means that you may not change the beneficiaries of the trust once you establish it.
If you are no longer happy with the terms of the ILIT, you can stop making gifts to the ILIT, let the policy lapse, and create a new ILIT which purchases a new policy. However, the cost of creating a new ILIT and purchasing a new policy may be cost-prohibitive depending on your age and health.
Do I need an ILIT?
It depends. Under current estate tax rules, most Americans will not be subject to any federal estate tax. However, some states have a substantially lower state estate tax. For example, Massachusetts and Oregon impose an estate tax on estates that exceed $1 million. If you have modest estate and a life insurance policy in one of those states, you may have a taxable estate that could benefit from an ILIT.
Texas doesn’t have a state estate tax. In Texas in 2023, only estates valued more than $12.92 million will be subject to estate tax under current laws. Not many of us will have estates that large when we die, even counting our insurance policies. So, creating an ILIT may seem like overkill.
Note, however, that estate tax laws are subject to change. In fact, even if Congress doesn’t pass any new legislation, the Tax Cut and Job’s Act will sunset in 2026. At that time, the estate tax exemption will be half. And when that happens, ILITs may become appealing to more Texans with large insurance policies.
Always talk to an attorney about which tools will help you accomplish your estate planning goals.
This article was originally published on January 9, 2021 and updated on August 17, 2023.