How to Use an Irrevocable Life Insurance Trust to Minimize Estate Taxes

April 4, 2023

This article is for educational and entertainment purposes only. This is not legal advice and should not be relied on as such. Every case is different. Consult a licensed professional in your state. Viewing this website or its content does not create an attorney-client relationship with Lyda Law Firm or any of its lawyers.

Authored by Eve Lumsden, Attorney Licensed in Florida

Death and taxes. We’ve all heard the old saying... for many who begin their estate planning journey, these two items are inextricably intertwined, and clients frequently have a goal of minimizing the implications of the former on the latter. When estate planning clients fill out my questionnaire, they almost always mark “avoiding estate taxes” as a high-priority item; who wants their hard-earned estate assets to be paid to the government as opposed to their loved ones? An experienced estate planning attorney has numerous tools to help with this concern; today’s tool: the irrevocable life insurance trust (ILIT). 

Many of us have life insurance policies or plan on purchasing them; they give us peace of mind that our loved ones will have short-term financial resources once we pass away. We buy them, name our beneficiaries, and tuck them away because hey, by the time they are paid out, we won’t be concerned with them anymore! While these policies are beneficial in a number of ways, they have the unfortunate effect of depleting your estate tax exemption upon your passing and could leave your loved ones owing thousands – up to millions –  of dollars in taxes.

Estate taxes are taxes levied on the net value of the assets of a deceased person before distribution to the estate’s heirs or, put another way, a tax on your right to transfer property at your death. According to the IRS, “It consists of an accounting of everything you own or have certain interests in at the date of death.”1 Includible items may consist of real estate, cash, business interests, other assets... and insurance. 

As of 2023, estates worth less than $12.92 million per individual are not subject to estate tax, which comes as a huge relief to many clients who anticipate not reaching that amount of wealth in their lifetimes. However, the 2017 law that so greatly increased the exemption has a “sunset” provision; barring further legislation, effective January1, 2026 the exemption will be cut in half and adjusted for inflation, and could end up around $7 million per individual. Think about those numbers – how much will your life insurance policies pay out upon your passing? How much will the worth of your assets increase between now and your passing? For some individuals, life insurance policies could pay millions to their estate. If those amounts are included in an individual’s estate when they pass away, they eat up much, if not all, of the exemption, and expose the remainder of the decedent’s estate to taxes. Further, the estate tax rate escalates based upon the value of the estate after the exemption. As an example, if the tax exemption rate is $7 million, and an individual’s estate is valued at $7,500,000 including $5 million of life insurance policy proceeds, the estate can claim the exemption of $7 million with $500,000 of nonexempt assets. As of 2023, those $500,000 in assets have a threshold tax rate of $34%; this amount will have to be paid by the estate. 

This is where an irrevocable life insurance trust may be a valuable protection against future estate taxes. The ILIT is a trust that either purchases life insurance policies or into which existing policies are transferred, transferring ownership of the policies from the individual to the trust. Creating this trust excludes the value of the policies from the decedent’s estate if the policies have been transferred more than 3 years before the death of the grantor or if the policies were purchased by the trust, thus reducing the likelihood that the value of the estate will surpass the tax cap. The creator (grantor) of the trust must avoid any ownership interest in the trust for it to qualify as an irrevocable trust and cannot be the trustee; therefore, once created, the trustee, usually a family member, will manage the trust and the designated beneficiaries will receive their distribution. Typically, the trustee pays the life insurance premiums, which in some circumstances can be paid by funds transferred by the grantor into the trust or from a bank account set up in the name of the trust. If the grantor is placing funds into the trust to pay insurance premiums, he should speak with his attorney or financial advisor about strategies to ensure that those funds qualify for the gift tax exclusion and do not trigger penalties.

The trust serves more purposes than simply estate tax protection; for example, if a beneficiary of the trust is receiving government aid for supplemental needs, the trustee of the ILIT can control distributions so as not to interfere with the beneficiary’s government aid eligibility. Further, holding the assets in trust shelters them from creditors (although creditors may attach claims to distributions made from the trust). The trust can be drafted to provide distributions when beneficiaries attain milestones such as graduating from college or having a child, and this is especially important in cases of second marriages when a spouse wants to ensure that assets are distributed to children from a prior relationship. And the proceeds of the trust can provide immediate liquidity to beneficiaries as opposed to time-consuming estate administration through probate. 

What are the down sides to having an ILIT? The first and most obvious is that the trust is irrevocable, meaning that once it is finalized very few, if any, changes can be made. The grantor must relinquish any rights to assets held in the trust. The grantor cannot be the trustee of the trust, and must find a party willing to take on the responsibility of the role for an undetermined length of time. In the case of life insurance policies, this means that the grantor must create the trust with great care to ensure that the terms of the trust conform exactly to the grantor’s wishes. As the grantor has no control over the policy once in the ILIT, no changes or beneficiary designations may be made to trust policies. Policy premiums tend to rise over time, and to keep a policy from lapsing, the grantor must plan for the policy to be funded appropriately over a potentially long period. Employer group policies may not be transferrable, so if the grantor has existing policies through their job they may still run afoul of tax consequences for policies outside of the trust. Finally, age is a consideration: there is a three-year lookback for existing insurance policies placed within the trust. If the grantor passes within that three year period, the policy payout will be included in the grantor’s estate upon his passing. However, this may be avoided by having the trust purchase the life insurance policy for fair value, which is typically much lower than the payout amount of the policy. 

Despite these drawbacks, ILITS are undoubtedly a beneficial wealth and estate planning option for many individuals and married couples. You should work closely with your attorney and financial advisor to ensure the trust is drafted and administered correctly to maximize benefits and utilize strategic tools to reduce risk.  If drafted and executed properly, an ILIT is a potentially important estate planning tool for investors of various wealth levels.

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