An irrevocable life insurance trust (ILIT) is a financial tool that holds your life insurance policy and pays the premiums on your behalf. An ILIT can help ensure the proceeds from your life insurance policy will pass directly to your beneficiaries. It can also ensure the funds are spent according to your wishes. On the other hand, an ILIT can’t be changed once it’s in effect, so you’ll need help from a legal expert to decide if it’s the right fit for you and to establish it.
Wealthy individuals with large estates may benefit from establishing an (ILIT) to help reduce the size of their taxable estate. Likewise, parents of minor children can use an ILIT to make sure their life insurance payout is used to support their child in their absence without having to go through probate court.
How does an insurance trust (ILIT) work?
A trust is a separate legal entity that holds your assets like money, real estate, and personal belongings, which can eventually be passed down to your future heirs. An ILIT is an irrevocable trust that holds your life insurance policy.
The trust acts as the policyholder, removing you from any “incidents of ownership” according to the IRS. [1] This means that the value of your policy no longer counts toward the value of your estate, for tax purposes.
When you die, the insurer will pay the death benefit to the trust. The death benefit also won’t be subject to probate, which is the legal process of administering your estate. This can save your beneficiaries time when claiming the money.
The trust will distribute the death benefit to your beneficiaries according to your wishes, as outlined in the trust document.
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Special considerations for ILITs
Three-year look-back period: If you die within three years of transferring the policy into the trust, the death benefit still counts as part of your estate. This stipulation is imposed by the IRS.
Federal limits for cash value contributions: If you have a permanent life insurance policy, overfunding your cash value could turn your policy into a modified endowment contract, which changes some of the tax implications around your policy.
Crummey powers: When you fund the trust, the money you transfer into it for premium payments is considered a gift and is subject to a gift tax by the IRS. You can avoid gift taxes on up to $18,000 in annual gifts by adding “Crummey powers” to your trust. [2] This gives your beneficiaries the ability to withdraw a limited amount of contributions from the trust within a certain period of time.
How to set up a life insurance trust
ILITs are complex and come with many tax implications. It’s vital to consult an attorney when you’re setting up a trust to ensure it’s properly implemented and works to your benefit.
Once you’ve begun the process of setting up the trust, you’ll need to make a few key designations.
The grantor: the insured individual whose death prompts the death benefit payout.
The trustee: the administrator of the trust, who cannot be the grantor.
The trust beneficiaries: the recipients of the funds from the trust.
The actual process of setting up the trust involves these steps:
Open and finance the irrevocable trust.
Fund the trust so that it can pay the policy’s premiums on your behalf.
Select a trustee.
Purchase or transfer an existing life insurance policy into the trust.
Designate how the trust will distribute the death benefit to your beneficiaries. These instructions are irrevocable and cannot be changed at a later date.
How to put life insurance into the trust
If you don’t have life insurance yet, you can purchase a life insurance policy through the trustee. In this case, you’ll designate yourself as the insured, and the trust as the policyholder. The trust should make the premium payments, not you.
If you already have a life insurance policy, you can transfer it to the trust with a change of ownership form. Contact your insurance company to make the ILIT the owner of your policy.
Remember that to successfully get the tax benefits of a life insurance trust, it must be set up at least three years before you die because of the IRS look-back period.
Who should have a life insurance trust?
ILITs are most suitable for individuals with a high net worth who want to prevent any unnecessary exposure to higher estate taxes.
If your estate is valued over the exemption limit ($13.61 million for individuals or $27.22 million for married couples in 2024), [3] you may want to consider this option.
If you’re a parent who wants to support their minor children, you can also use an ILIT to ensure the benefit is spent on your child’s care and doesn’t get tied up in court.
Another major benefit of using an ILIT is that creditors can’t claim life insurance proceeds held in a trust, so if this is a concern of yours, you may want to discuss implementing a trust with a financial advisor.
Most people won’t need to incorporate the complexity of an ILIT into their end-of-life planning and can instead pair their insurance policy with a strong will and revocable trust. Because ILITs can’t be changed after you establish them, this tool is best for people with specialized estate planning needs. If you’re considering adding an ILIT to your financial plan, you can meet with a financial advisor to review your personal situation.
