Irrevocable Life Insurance Trusts (ILITs): Leveraging Life Insurance for Estate Planning

Gabriel Katzner - December 7, 2023 - Estate Planning

Mark, a single parent of two daughters aged 9 and 11, has an estate valued at $17 million and plans to purchase a life insurance policy with a $5 million death benefit. Mark’s estate is currently valued at $22 million, which is over the federal estate tax exemption maximum and, therefore, would incur estate taxes.

To protect his estate’s value for his daughters. Mark created an irrevocable life insurance trust (ILIT), and the trust became the owner and beneficiary of the life insurance policy.

Mark’s sister is the trustee of the ILIT, and she has agreed to be the guardian of his two children. By establishing an ILIT, Mark reduces his state and federal estate taxes and ensures that his daughters will be financially provided for in the event of his death.

What is an ILIT?

An ILIT is an estate and financial planning tool that is used to manage term or permanent life insurance policies while the grantor is alive and to distribute the proceeds upon their death.

The grantor (the person who establishes the trust) places the life insurance policy in the irrevocable trust and names a trustee. The life insurance policy is purchased with the grantor being the insured, but the trust is the owner and beneficiary of the policy.

The trustee pays the life insurance premiums, collects the death benefits when the insured person dies, and disburses the payouts from the life insurance to the beneficiaries as stipulated in the trust documents. Typically, the grantor will gift money to the trust that the trustee can use to pay the insurance policy premiums.

The beneficiaries receive the life insurance payouts.

Since the ILIT owns the life insurance policy and the trust exists separately from the grantor, it is not included in the grantor’s estate valuation upon their death.

The trustee must keep the trust management separate from the grantor’s estate. For example, Mark’s sister should pay all life insurance premiums using a checking account owned by the ILIT.

What are the potential benefits of an ILIT?

An ILIT has several potential benefits, including:

  • Estate tax mitigation: The primary purpose for funding a trust with an insurance policy is to help reduce or eliminate estate taxes. With a properly established ILIT, Mark’s $2 million life insurance policy would not be considered to be part of his taxable estate, which would lower his estate tax liability.
  • Asset protection: Since the ILIT, not Mark, owns the life insurance policy, the policy’s cash value would be shielded from his creditor’s claims. Laws vary by state on how much cash value or death benefits are protected from creditors.
  • Control over disbursements: When Mark established the ILIT, he specified how the insurance policy proceeds would be disbursed. He had the option to describe how the insurance funds could be used. Mark can transfer other assets into the ILIT, or the trust could make a loan to his estate. This can provide liquidity to help pay his estate taxes, debts, or expenses. By following the trust instructions, Mark’s sister could use the trust money to pay his estate taxes and provide for his daughters.
  • Wealth transfer: An ILIT makes it possible for Mark to transfer the value of his life insurance policy to his daughters while minimizing the tax implications.
  • Gift taxes: A properly drafted ILIT can help reduce or avoid gift taxes.
  • Protect government benefits: If Mark’s daughters received government benefits such as Social Security disability income or Medicaid, the trust disbursements can be set up so they do not interfere with his daughter’s eligibility to receive government benefits.

What are the potential drawbacks to an ILIT?

When establishing an ILIT, consider these potential drawbacks:

  • Irrevocable nature: An ILIT is irrevocable, meaning that Mark cannot change the trust without the beneficiaries’ consent. An ILIT must be irrevocable in order to provide protection from potential creditors and to reap estate tax benefits, but its irrevocable nature means that grantors must be very thoughtful when establishing an ILIT.
  • Requires planning: An ILIT must be created during the grantor’s lifetime. Since it is irrevocable, an ILIT generally cannot be altered or changed once the trust is established. Even though Mark is paying the insurance policy premiums, he cannot change the beneficiaries or the policy’s value.
  • Lookback period: If Mark transfers his existing life insurance policy to the ILIT within three years of his death, the death benefits may be included in his estate.
  • Complexity: To attain the maximum value from an ILIT, they must be structured so that the annual grantor contributions to cover the insurance premiums qualify for the gift tax exemption.

The current U.S. federal estate tax exemption for 2023 for individuals is $12.92 million. For married couples, the combined exemption amount is $25.84 million. For most people, these high exemption amounts mean they do not need to be concerned about federal estate taxes.

However, this generous law will sunset in 2025, and it is currently unclear what the estate tax exemption will be after the law changes. An ILIT is an estate planning tool that can help protect against implications due to potential future changes in the estate tax exemption.

ILITs are complicated trusts to establish so they serve their intended purposes. If you are interested in establishing an ILIT or another trust, contact an attorney at Katzner Law Group to discuss your estate plans.

You are welcome to schedule a call with us or reach us directly at 855.434.2062 to learn more about how best to plan today to protect those most important to you.

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