Why It’s Done

The primary reason to establish an Irrevocable Life Insurance Trust (ILIT) is to remove the death benefit proceeds of a life insurance policy from your taxable estate. This can significantly reduce your estate tax liability, especially if you have a substantial estate. However, there are other benefits to this practice with some noted below.

1. Estate Taxes: Taxes play a key role in estate planning. For policyholders who are both the owner and insured, the death benefit of that policy will be included in your estate. This is through “incidents of ownership.” While the current federal tax exemption limit may be high ($13.6 million per person as of 2024), it’s important to note that tax laws can change over time. With the Tax Cuts and Jobs Act of 2017 set to expire at the end of 2025, an ILIT can provide a layer of protection against potential increases in estate taxes in the future.
2. Asset Protection: An ILIT can help protect your life insurance proceeds from creditors and potential lawsuits. If you were to become involved in a legal dispute, the proceeds within the trust would generally be shielded from creditors including those owed due to Medicaid.
3. Flexibility and Control: An ILIT allows you to specify how the life insurance proceeds will be distributed to your beneficiaries. You can establish specific terms and conditions, such as creating trusts for minor children or providing for special needs beneficiaries.
4. Privacy: By transferring the life insurance policy to an irrevocable trust, you can keep the details of your estate plan private. This can be important for individuals who prefer to keep their financial affairs confidential.

Timing – Estate Clawback

To ensure that the proceeds of the life insurance policy are not included in the insured’s estate, it’s crucial to meet certain requirements. One such requirement is that the insured must outlive the policy by at least three years. This prevents any potential arguments that the policy was transferred in contemplation of death. Furthermore, it’s important that there are no incidents of ownership – giving the former policy owner (a.k.a the grantor) the ability to amend, revoke, or terminate the policy once it’s in the trust.

Taxes – Gift Tax Trap

To maintain the policy, the trust is required to pay the premiums. This is accomplished by making annual gifts to the trust, which could result in gift tax. However, the use of a ‘Crummey’ power can help avoid gift tax associated with this. The Crummey power allows the beneficiaries of the trust to have a temporary right to withdraw the annual gifts made to the trust. By having this option, beneficiaries can help ensure that the gifts which are used to pay for the premiums qualify for the annual gift tax exemption.

The Takeaways

ILITs are valuable estate planning tools, but they can be complex to set up and require careful consideration. While they are often associated with high-net-worth individuals seeking to minimize estate taxes, ILITs can offer significant benefits for individuals of all income levels. It’s essential to work closely with an estate planning attorney and in conjunction with your financial advisor. Together, they can help you understand the specific requirements, potential benefits, and potential drawbacks of setting up an ILIT for your unique circumstances. By considering factors such as your estate size, financial goals, and family structure, you can determine if an ILIT is the right choice for your estate planning strategy.