Discover 10 ways an irrevocable life insurance trust can save your estate

An irrevocable life insurance trust, commonly referred to as an ILIT, is a trust that one funds during their lifetime with life insurance policies. An ILIT can contain both individual policies as well as second-to-die life insurance policies that insure two lives and pay the death benefit when both insureds die. Like other trusts, an ILIT contains a grantor, trustee and beneficiaries. The grantor is the person who creates and funds the trust.

The trustee is the person designated by the grantor to manage the trust in accordance with its terms, and the beneficiaries are those individuals or entities that receive the distributions from the trust. Since these types of trusts are irrevocable, once they are created, the grantor cannot control, revoke or change it in any manner.

Although a grantor loses control after the trust is created, they are able to control its use by how they set up the trust. A grantor can set up a trust to, for instance, provide distributions in a lump sum, periodically or when the beneficiary attains a milestone such as a certain age or upon having a child. Once the ILIT is created, it will be used to manage and distribute the proceeds that are paid out upon the insured's death in accordance with the specific provisions of the trust.

There are several benefits to having an ILIT as part of your overall estate plan. Here are 10 reasons why an ILIT may be beneficial for you to include in your estate plan:

1. Liquidity

An ILIT is a great way to ensure that your family has the necessary liquidity to handle time-sensitive expenses and other matters that need to be taken care of promptly. It may be that an estate does not have other liquid assets such as a checking or savings account to use for immediate expenses. Selling illiquid assets such as a house or business is not a practical solution when expenses start to become due. Providing access to an immediate source of cash can help your family stay on top of paying things such as funeral expenses, tax bills, mortgages and other debts without having to have a “fire sale” or incurring unnecessary penalties and interest on these expenses.

2. Business continuity

ILITs can be especially helpful if you have a business that you want to last for several generations. Whether you are in an established business with multiple partners, or you simply want to pass down your small family-owned business, an ILIT can help ensure this happens.

For business owners, a continuity plan is essential. An important part of this continuity plan is determining who you want your business interest to go to and how they are going to secure that interest. One way to do so is to set up an ILIT for your successor that provides them with the necessary funds needed to buy your interest in the business.

Doing it this way ensures the beneficiary has sufficient funds to purchase your business interest while keeping these funds out of the estate and, as a result, not subject to estate or inheritance taxes. Failure to make these types of provisions may result in having to sell your business or other high-value assets to pay for the expenses and costs of the estate.

3. Asset preservation

Having a beneficiary's assets in an ILIT can ensure that the assets are preserved from certain unplanned life events such as a lawsuit or divorce. It can also be used to protect assets from any creditors' claims. Of course, this may be subject to state rules and limits as to the amount of death benefit that is protected from creditors.

Another way it preserves assets is by protecting assets being given to a beneficiary with spending or other related issues. It could be that the person has a substance abuse issue or is simply just bad with managing money. Either way, an ILIT allows you to still provide your beneficiary with an inheritance, while simultaneously ensuring that the money will be properly spent. The appointed trustee will be able to supervise the trust and only distribute proceeds according to the grantor's wishes and the terms memorialized in the trust.

4. Asset replacement

An ILIT can function as an asset replacement in multiple ways. First, it may be that your income is relied on by your spouse or another beneficiary. The death benefit funds in an ILIT can be used to replace that lost income. It could also be used to make sure that your beneficiaries receive an inheritance when you want to use part of your estate assets for a specific purpose.

For instance, you may own land that you want to convey philanthropically to a land trust for preservation or to a charity. At the same time, you do not want to leave your beneficiaries without an inheritance. You can replace the loss of this asset by setting up your beneficiaries with an inheritance under an ILIT. Using the same example, you could simply set up an ILIT to make certain that any costs or taxes for the estate assets are properly paid off without having to sell a portion of your assets that you specifically wanted to bequest.

5. Estate equalization

It may be that you have a particular asset that you want to give to just one of your beneficiaries. However, you want to make sure that your other beneficiaries receive an equal share of your estate. How do you go about ensuring your estate accomplishes both of these goals? An ILIT can be the solution to this problem. Let's say you have a family business worth approximately $1 million, and you have two children that you want to give your estate to equally.

Splitting the business could be complicated and potentially lead to family complications. Also, it might be that only one of the children is involved in the family business. One way to resolve this issue is to give the business to the one child and set up a $1 million ILIT with the other child as the sole beneficiary. This way, both goals can be met. The assets are equally divided, and the business goes to the child that you wanted to inherit it.

6. Education funding

ILITs can be used in unique ways such as providing educational funding for one's beneficiaries. One way to do this is to simply set up specific instructions in your ILIT for using its funds to pay for educational needs.

Another way this can be done is by having a 529 account (an education savings account) as the beneficiary to the ILIT. Doing this will provide you the peace of mind that your children and other beneficiaries will be able to pursue their educational endeavors even after you pass away.

7. Special needs funding

ILITs can also be used to help provide for a beneficiary with special needs. Typically, individuals with special needs are provided their inheritance in the form of a special needs trust. These trusts are used to provide funds for a beneficiary with special needs while ensuring they are not disqualified from any government benefits they may receive such as Supplemental Security Income or Medicaid.

Special needs trusts can be beneficiaries of life insurance policies held by ILITs, and it is a great way to guarantee that a special needs trust will be adequately funded. Life is uncertain, and an ILIT with guaranteed life insurance funds can give families the peace of mind that, regardless of what circumstances they may face, their beneficiaries' special needs trust will not be negatively impacted.

When the insured dies, the life insurance proceeds in the ILIT will pass to the special needs trust that will then be maintained by a trustee for the benefit of one's beneficiary. It's important to make sure you carefully craft an ILIT that is going to be used to fund a special needs trust. If done improperly, it could cause the beneficiary to lose certain government benefits that the trusts were designed to protect.

8. Estate tax payments

Having an ILIT can help with estate tax payments in two ways. First, death benefits resulting from an ILIT are not included in one's gross estate. This means, these funds are not subject to probate and any potential state or federal estate taxes.

Second, if estate taxes from your probate estate are due, you have the ability to structure your ILIT to use its funds to pay those taxes. You can either use the life insurance funds in the trust as a loan to the estate to make these payments or by using these funds to purchase assets from the estate. The funds received from any purchases can then be used to make any estate tax payments. While 2022 federal estate tax exemption is $12.06 million, that number can always be lowered (currently these higher limits are set to revert back to its previous limit of $5 million beginning in 2026). Also, there are still state estate and inheritance taxes to consider.

9. Gift taxes

Using an ILIT can also help with taxes you might incur while you are still alive as well. Contributions to an insurance policy are considered a gift to its beneficiaries. An ILIT can help you avoid any potential gift taxes you might incur but you must make sure that the trustee takes specific steps to avoid paying any gift taxes. In its most simplistic form, a trustee must send what's known as a Crummey letter to any beneficiary to notify them of their right to withdraw a share of the contributions for 30 days.

Once those 30 days have passed, the trustee can use the contributions a grantor has made to pay any insurance policy premiums for policies that are part of the trust. Sending this letter qualifies the transfer under the annual gift tax inclusion, which in 2022 allows you to gift $16,000 per person each year to as many people as you want, tax-free. There are more intricacies that may be involved such as the potential use of your lifetime estate tax exemption. For more information, a qualified estate planning attorney can explain to you these intricacies and any potential ramifications in detail.

10. Legacy planning

Having an ILIT can help provide assets to multiple generations while avoiding burdensome taxes such as the generation-skipping transfer ax (GSTT). The GSTT imposes a 40% tax on gifts and transfers in a trust for the benefit of either:

1. Unrelated persons more than 37.5 years younger than the donor
2. Related persons more than one generation younger than the donor (i.e., a gift to your grandchildren)

An ILIT can be used by taking gifts from the grantor and using them to fund life insurance policies to either of these types of people. Since the proceeds from these policies are excluded from the grantor's estate, funds can be provided for multiple generations while avoiding any estate or generating-skipping transfer taxes.

While there are several benefits to an ILIT, it is important to understand some potential negative ramifications as well.

1. Loss of control

When creating an ILIT you, as the grantor, give up control once the trust is created. Once an ILIT is created it is final. If you come upon a financial crisis or need cash for any reason, you have no access to any of the assets placed in this trust and will have to find another means to assist you.

2. Tax burden

While an ILIT may remove the tax burden from your estate, it may create one for its beneficiaries. Any investment income earned in the trust after death benefits have been provided can be taxed. In addition, the funds distributed from an ILIT to a beneficiary could subject their estate to future taxes, leaving a potential burden for their beneficiaries.

3. Incidents of ownership

This is an issue that can occur if an ILIT is not properly prepared. ILITs must not allow the grantor to retain any rights to amend the trust or modify the insurance policy within the trust in any way. To protect from this, an ILIT cannot show any signs of grantor ownership. This means that there can be no power of attorney or any right reserved to the grantor to modify the life insurance policy or trust in any manner. If this is done, the proceeds from the trust will no longer be protected and will become a part of one's taxable estate.

In addition, the designated trustee cannot be one of the beneficiaries either. Doing so would void their creditor protection as a beneficiary.

4. Look-back period

ILITs have a three-year look-back period. Any insurance policies placed in this type of trust within three years of the grantor dying will be included in the grantor's estate. This means that all of the benefits that this trust is designed to provide will no longer be available if the assets have been in the trust for less than three years.

ILITs are a great tool with numerous benefits. However, they are not necessary for every estate plan. In addition to knowing whether an ILIT is the right tool for your estate, you also want to make sure it is set up properly. The preparation of ILITs are complex with strict requirements and procedural rules that must comply with IRS guidelines.