An irrevocable life insurance trust — commonly called an ILIT — is a type of irrevocable trust specifically designed to hold a life insurance policy outside of the insured’s taxable estate. When structured and administered correctly an ILIT can remove the life insurance death benefit from the insured’s taxable estate potentially saving significant estate taxes while still allowing the death benefit to benefit the insured’s heirs.
ILITs are one of the most widely used estate planning tools for people with large estates who want to provide liquidity for estate taxes or other expenses at death while minimizing the overall estate tax burden.
How an irrevocable life insurance trust works
When a person creates an ILIT they establish an irrevocable trust and name a trustee to manage it. The trust — not the insured — then purchases a life insurance policy on the insured’s life. Because the trust owns the policy rather than the insured the death benefit is generally not included in the insured’s taxable estate when they die.
When the insured dies the life insurance death benefit is paid to the trust. The trustee then manages and distributes the proceeds to the trust’s beneficiaries — typically the insured’s spouse and children — according to the terms of the trust document.
Why life insurance is included in the taxable estate without an ILIT
Many people are surprised to learn that life insurance death benefits are included in their taxable estate if they own the policy at the time of death. The IRS includes life insurance in the taxable estate when the insured has what are called incidents of ownership — the right to change beneficiaries, borrow against the policy, cancel the policy, or assign ownership.
For people with large estates the inclusion of life insurance in the taxable estate can significantly increase the estate tax burden. An ILIT solves this problem by transferring ownership of the policy to the trust which is a separate legal entity from the insured.
The three year rule
An important timing consideration for ILITs is the IRS three year rule. If an existing life insurance policy is transferred into an ILIT and the insured dies within three years of the transfer the death benefit is included in the insured’s taxable estate as if the transfer never happened.
To avoid the three year rule it is generally better to have the ILIT purchase a new policy directly rather than transferring an existing policy into the trust. When the trust purchases the policy from the beginning the insured never owns the policy and the three year rule does not apply.
Crummey powers and gift tax
When funding an ILIT the insured typically makes annual gifts to the trust to pay the insurance premiums. These gifts are subject to the federal gift tax unless they qualify for the annual gift tax exclusion — $18,000 per recipient in 2024.
For gifts to a trust to qualify for the annual exclusion they must be gifts of a present interest — meaning the recipient must have an immediate right to use the gift. Because trust assets are not immediately available to beneficiaries gifts to a trust are normally gifts of a future interest that do not qualify for the annual exclusion.
ILITs use a mechanism called Crummey powers to solve this problem. The trust document gives each beneficiary a limited right — typically lasting 30 to 60 days — to withdraw their share of each gift to the trust. This right of withdrawal — even if never exercised — converts the gift into a present interest gift that qualifies for the annual exclusion.
The trustee notifies beneficiaries of each gift and their withdrawal right through a Crummey notice. Maintaining proper Crummey notice records is an important part of ILIT administration.
What an ILIT can provide
In addition to removing life insurance from the taxable estate an ILIT can serve several other important purposes:
- Estate liquidity — when a person dies their estate may face significant expenses including estate taxes, debts, and administrative costs. These expenses must generally be paid in cash within a relatively short time. An ILIT can provide liquid funds to pay these expenses without requiring the forced sale of illiquid assets such as real estate or a family business.
- Providing for a surviving spouse — the trust can be structured to provide income to a surviving spouse during their lifetime while ultimately passing the remaining assets to children or other heirs
- Protecting assets for beneficiaries — the trust can include spendthrift provisions and other protections that shield the death benefit from beneficiaries’ creditors and poor financial decisions
- Special needs planning — an ILIT can be structured as a special needs trust to provide for a beneficiary with a disability without disqualifying them from government benefits
Administration of an ILIT
An ILIT requires ongoing administration to maintain its tax benefits and legal validity. Key administrative requirements include:
- Maintaining a separate trust bank account — the trustee must maintain a separate bank account in the trust’s name for trust funds
- Sending Crummey notices — the trustee must send written notices to beneficiaries each time a gift is made to the trust informing them of their withdrawal rights
- Maintaining records — the trustee must keep detailed records of all trust transactions including gifts, premium payments, and Crummey notices
- Filing tax returns — the trustee must file annual income tax returns for the trust if the trust has taxable income
Failure to follow proper ILIT administration procedures can jeopardize the trust’s tax benefits and potentially cause the death benefit to be included in the insured’s taxable estate.
Who should consider an ILIT
An irrevocable life insurance trust may be worth considering for people who:
- Have a large estate that may be subject to federal or state estate taxes
- Own significant life insurance and want to remove the death benefit from their taxable estate
- Want to provide liquidity for estate taxes or other expenses at death without increasing the taxable estate
- Want to provide for a surviving spouse while ultimately passing assets to children
- Have a beneficiary with a disability who needs a special needs trust
- Want to protect an inheritance from beneficiaries’ creditors or poor financial decisions
Key terms to know
- Irrevocable life insurance trust — ILIT — an irrevocable trust designed to hold life insurance outside the insured’s taxable estate
- Incidents of ownership — rights in a life insurance policy that cause the death benefit to be included in the insured’s taxable estate
- Three year rule — an IRS rule that includes life insurance transferred into a trust within three years of the insured’s death in the taxable estate
- Crummey powers — a mechanism that gives trust beneficiaries a limited right to withdraw gifts to the trust qualifying those gifts for the annual gift tax exclusion
- Crummey notice — written notice to beneficiaries of each gift to the trust and their withdrawal rights
- Annual gift tax exclusion — the amount that can be given to any individual per year without using the lifetime gift and estate tax exemption — $18,000 in 2024
- Estate liquidity — the availability of cash or liquid assets to pay estate taxes and other expenses at death
Sources
- Internal Revenue Service — irs.gov
- American Bar Association — Public Resources
- USA.gov — Estate Planning
This article is for general informational purposes only and does not constitute legal or financial advice. Tax laws and trust regulations vary and are subject to change. Consult a licensed attorney and tax professional for guidance specific to your situation.