What Is an Irrevocable Life Insurance Trust (ILIT)?

Life insurance policies provide a plethora of tax advantages depending on the policy and your circumstances, especially regarding its beneficiary. But for you, the policyholder, a large life insurance policy payout after your death may count towards your estate’s total value and potentially push you over the edge of the federal and/or state estate tax exemption limit.

Estate taxes are usually quite severe, and any assets or property exceeding the exemption limit will be heavily taxed at the time of death. This can include life insurance policies. Because while the payout is immediately transferred to a designated beneficiary and thus skips probate, the policy's value is still part of your final estate.

And while the exemption limit for the estate tax remains relatively high, that exemption limit can be greatly reduced in the coming years. Thankfully, there are ways to limit the tax impact of utilizing a life insurance policy. One of these ways is through a specialized trust called an irrevocable life insurance trust (ILIT).

An irrevocable life insurance trust takes ownership of the life insurance policy. It separates it from your estate, allowing you to generate a large sum still to be paid out to your heirs without contributing to your estate's final value.

The Anatomy of a Living Trust

Understanding how this specialized trust can help your estate avoid an unnecessarily high tax bill is essential to understand how living trusts work. While a will goes into effect upon your death, a living trust goes into effect as soon as it is notarized.

Trusts are entities formed and defined by trust documents, with the intended purpose of holding assets and properties “in trust” for one or more beneficiaries. An assigned trustee is appointed after the grantor or trustor (you) dies. Their fiduciary duty to the trust and its beneficiaries requires them to distribute the trust contents as per the document’s specifications (i.e., your wishes).

Trusts are a separate entity from the trust’s grantor, with varying degrees of separation based on the trust's wording and specifications. To make use of a trust, any assets and properties listed within the document or its attached asset list must be funded into the trust.

In other words, ownership documents and deeds must be written and amended to clarify that these assets and properties are now part of the trust rather than the grantor’s own property. To explain a trust’s flexibility, it is worth noting that the grantor, trustee, and beneficiary of the trust can be the same person.

But being a trust’s grantor and heir, for example, limits trust’s usefulness as a tool for asset protection and tax avoidance. The same goes for making a trust revocable, which allows the grantor to retain certain rights over the assets in the trust throughout their lifetime. Therefore, an ILIT is irrevocable.

Revocable and Irrevocable Trusts

Revocable living trusts can be amended at any time. Irrevocable living trusts cannot be amended without the consent of the beneficiaries. Whereas revocable living trusts do not separate the contents of the trust from the grantor’s estate, irrevocable living trusts do.

This means they serve as a form of asset protection and can reduce the grantor's taxable estate after death. However, irrevocable living trusts are typically more difficult to set up and are often specialized for a particular purpose. It would be best if you only created an irrevocable living trust with an estate planning professional's help.

Why Use an Irrevocable Life Insurance Trust (ILIT)?

There are other reasons to use an irrevocable life insurance trust to avoid a hefty estate tax bill. ILITs serve to control better how and when your life insurance policy proceeds are paid out and their other tax considerations where an ILIT can help ensure your heirs receive a more significant portion of their inheritance.

For example, through an ILIT, you can attach conditions to the insurance policy's payout to encourage thrifty spending or prepare it for a younger beneficiary who might not yet have the legal or mental capacity to care for their future windfall properly. Other reasons include:

• • • For beneficiaries receiving government aid. Life insurance policies can amount to a large sum, which may not be in the best interests of a beneficiary receiving government benefits. Their eligibility may be challenged by a larger inheritance, mainly if it is distributed all at once. But an irrevocable life insurance policy can be used to distribute that inheritance one portion at a time through the trustee not to disrupt the beneficiary’s eligibility.
    • For asset protection. When you die, your estate undergoes a probate process to determine your will's legitimacy and oversee the distribution of your assets. One of the first steps in any probate process is to inform creditors of your passing and provide ample time for them to file claims against the estate. However, irrevocable trusts separate assets from your estate, making them safe from creditors as well – under most circumstances, at least. Be sure to consult an estate planning professional for more information about specific asset protection trusts and how they may serve your circumstances.

Other Important Tax Considerations

Irrevocable life insurance trusts can be used to avoid the estate tax and minimize or entirely avoid the generation-skipping transfer tax (GSTT). The GSTT must be carefully considered when setting up and funding an ILIT, alongside gift tax considerations. Irrevocable living trusts are also subject to separate and strict income tax schedules.

However, the money accumulating in a life insurance policy is tax-free, as is the death benefit. An ILIT would still be taxed on income gained outside of the death benefit after the grantor’s death, during the distribution period. As an irrevocable trust, many complexities are surrounding a specialized ILIT. An experienced estate planning and tax professional can help guide you through them.