Estate planning Q&A: Irrevocable Life Insurance Trusts explained

An Irrevocable Life Insurance Trust (“ILIT”) can be a valuable estate planning tool. By removing life insurance proceeds from your taxable estate and providing liquidity to your loved ones after your death, an ILIT can offer significant advantages. When strategically structured, gifts you make to an ILIT can qualify for the gift tax annual exclusion, preserving your lifetime gift and estate exemption for other uses.  

What is an ILIT?

An ILIT is an irrevocable trust that holds one or more life insurance policies, where the ILIT itself owns the policy and is the designated beneficiary. The provisions of the ILIT provide for the ultimate distribution of the policy proceeds. You can fund the ILIT to pay premiums in a manner that typically avoids gift or income tax implications.  Upon your death, the life insurance proceeds are paid directly to the ILIT. Since the ILIT, and not your individual estate, owns the policy, the proceeds are excluded from your taxable estate.   

What are the requirements for setting up an ILIT?

• The ILIT must be irrevocable. This means that once the ILIT is executed, you generally cannot make changes.
• You can either fund the ILIT with an existing policy, or transfer funds to the ILIT for it to purchase a new policy.
• You must ensure the proper ownership of the policy is reflected by the insurance company to remove the policy proceeds in your taxable estate.

What are some of the benefits of an ILIT?

• ILITs are generally structured as grantor trusts, which can offer significant income and transfer tax benefits.
• Gifts to the ILIT (typically in the form of premium payments on behalf of the ILIT or cash transferred to the ILIT so that it can pay the premium payments) can be structured to qualify for the gift tax annual exclusion.
• The life insurance proceeds can provide necessary liquidity to pay estate taxes, preventing the need to sell other estate assets.
• Proceeds of the life insurance policy are not subject to estate tax in your estate at death.
• ILITs can be used for multigenerational planning, by allocating your available generation-skipping tax (GST) exemption, you can shield the ILIT assets, specifically the likely significant life insurance proceeds, from the generation-skipping transfer tax (GSTT).  

What are the potential downsides of utilizing an ILIT?

• Once established, since the ILIT is irrevocable, you cannot easily change beneficiaries, terms, or access the assets within the ILIT. In most cases, you cannot be a trustee of the ILIT.
• You may need to file annual gift tax returns if gifts exceed or are not eligible for the gift tax annual exclusion, or to track the use of GST exemption.
• While the gift tax annual exclusion can be utilized in some cases, utilizing it for the ILIT premium transfers impacts the amount you are able to give loved ones outside of the ILIT gifts.
• The premiums for certain policies held by the ILIT may increase substantially, causing you to make larger gifts to the ILIT to fund premiums. These larger gifts may erode your gift tax exemption or give rise to gift taxes.

Is an ILIT right for you?

ILITs can be a strategic way to keep proceeds of life insurance out of your estate while providing liquidity to your family. By understanding the requirements, advantages and potential downsides, you can make an informed decision about whether an ILIT is right for your estate planning needs.