Irrevocable Life Insurance Trusts (ILITs): Estate Planning Benefits

What Is an Irrevocable Life Insurance Trust?

An irrevocable life insurance trust, often called an ILIT, is a special type of trust designed to own a life insurance policy. When the trust owns the policy instead of you, the death benefit is removed from your taxable estate. This can save your heirs a significant amount in federal estate taxes.

The word "irrevocable" is key. Once you create this trust, you cannot change it, cancel it, or take back the assets inside it. You give up ownership and control of the life insurance policy. The trust becomes the permanent owner and beneficiary of the policy.

ILITs are a common estate planning tool for wealthy individuals and families. They are most useful when your total estate is large enough to face federal estate taxes. Without an ILIT, your life insurance death benefit is included in your estate and could be taxed at rates up to 40 percent.

How Life Insurance Creates an Estate Tax Problem

Many people do not realize that life insurance death benefits count as part of your taxable estate. While the death benefit is income tax-free to your beneficiaries, it is not estate tax-free. If you own the policy when you die, the full death benefit is added to the value of your estate for federal estate tax purposes.

For example, suppose your estate is worth $10 million and you own a $3 million life insurance policy. When you die, your estate is valued at $13 million for estate tax purposes. Any amount over the federal estate tax exemption is taxed at up to 40 percent.

The federal estate tax exemption has changed multiple times over the years. The Tax Cuts and Jobs Act of 2017 temporarily doubled the exemption, but key provisions are scheduled to sunset. When the exemption decreases, more estates will face estate taxes. This makes ILITs an increasingly important planning tool.

An ILIT solves this problem by removing the life insurance policy from your estate entirely. If the trust owns the policy, the death benefit is not part of your estate and is not subject to estate tax.

How an ILIT Works Step by Step

Setting up and maintaining an ILIT involves several steps. Here is how the process works from start to finish.

• Step 1: Create the trust. You work with an estate planning attorney to draft the trust document. The trust names the grantor (you), the trustee (the person who manages the trust), and the beneficiaries (the people who receive the trust assets after your death).
• Step 2: The trust applies for life insurance. The ILIT applies for a new life insurance policy on your life. The trust is both the owner and the beneficiary of the policy. This is the preferred method because it avoids the 3-year rule.
• Step 3: You make gifts to the trust. You give money to the trust each year to pay the policy premiums. These gifts should qualify for the annual gift tax exclusion. To qualify, you must send Crummey letters to the beneficiaries.
• Step 4: The trustee pays the premiums. After the Crummey withdrawal period ends and no beneficiary has withdrawn the funds, the trustee uses the money to pay the life insurance premium.
• Step 5: When you die, the trust collects the death benefit. Because the trust owns the policy, the death benefit goes to the trust, not directly to your beneficiaries. The death benefit is not included in your taxable estate.
• Step 6: The trustee distributes funds to beneficiaries. The trustee follows the instructions in the trust document to distribute the death benefit to your beneficiaries. The trust can specify how and when distributions are made.

This process repeats each year you are alive. You make gifts to the trust, Crummey letters are sent, and the trustee pays the premium. It requires ongoing attention and administration.

Understanding Crummey Letters

Crummey letters are a critical part of how an ILIT works. They are named after a landmark tax court case called Crummey v. Commissioner. These letters make your gifts to the trust qualify for the annual gift tax exclusion.

Here is how it works. When you give money to the ILIT to pay the insurance premium, that gift is technically a gift to the trust, not directly to the beneficiaries. Gifts to trusts normally do not qualify for the annual gift tax exclusion because they are considered future interest gifts.

The Crummey letter solves this problem. Each time you make a gift to the trust, the trustee sends a letter to each beneficiary notifying them that they have the right to withdraw their share of the gift. This withdrawal right usually lasts 30 days. Giving the beneficiaries this present right to withdraw converts the gift from a future interest gift to a present interest gift, which qualifies for the annual exclusion.

In practice, beneficiaries almost never exercise their withdrawal right. If they did, there would not be enough money to pay the insurance premium. But the legal right to withdraw must exist and be communicated in writing. Failing to send Crummey letters can cause the IRS to disallow the gift tax exclusion, which could create unexpected tax consequences.

The 3-Year Rule for Existing Policies

If you already own a life insurance policy and want to transfer it into an ILIT, you need to be aware of the IRS 3-year rule. Under Internal Revenue Code Section 2035, if you transfer a life insurance policy to an ILIT and die within three years of the transfer, the death benefit is still included in your taxable estate.

This rule exists to prevent people from transferring assets out of their estate right before death to avoid estate taxes. The IRS treats the transfer as if it never happened if you die within the three-year window.

There are two main ways to avoid the 3-year rule.

• Have the ILIT buy a new policy. If the trust applies for and purchases a new life insurance policy from the start, the 3-year rule does not apply. The trust has always owned the policy, so there is no transfer to trigger the rule.
• Transfer an existing policy and survive three years. If you transfer an existing policy into the ILIT and live for more than three years after the transfer, the policy is successfully removed from your estate. The risk is that you might not survive the three-year period.

Because of the 3-year rule, most estate planning attorneys recommend having the ILIT purchase a new policy whenever possible. If you must transfer an existing policy, consider buying a separate term policy to cover the estate tax risk during the three-year waiting period.

Benefits of an ILIT

An ILIT offers several important benefits for estate planning. Here are the main advantages.

• Estate tax reduction. The primary benefit is removing the life insurance death benefit from your taxable estate. For a $3 million policy with a 40 percent estate tax rate, this could save $1.2 million in estate taxes.
• Creditor protection. Because the trust owns the policy, the death benefit is generally protected from the creditors of both you and your beneficiaries. This shields the money from lawsuits, bankruptcy, and other claims.
• Control over distributions. The trust document specifies how and when the death benefit is distributed to beneficiaries. You can set conditions, create staggered distributions, or restrict access for minor children until they reach a certain age.
• Liquidity for estate taxes. Even though the death benefit is outside your estate, the trust can be structured to provide cash to pay estate taxes on other assets in your estate. This prevents your heirs from having to sell property or other assets to pay the tax bill.
• Generation-skipping benefits. An ILIT can be designed to benefit multiple generations, potentially avoiding estate taxes at each generational level.

Drawbacks of an ILIT

ILITs are powerful estate planning tools, but they come with real downsides. You should understand these drawbacks before committing to one.

• Irrevocable means permanent. Once the trust is created, you cannot change it or take back the policy. If your circumstances change and you no longer need the trust, you are generally stuck with it.
• Setup costs. Creating an ILIT requires an experienced estate planning attorney. Legal fees typically range from $2,000 to $5,000 or more. Complex trusts cost more.
• Ongoing administration. The trust requires annual Crummey letters, premium payments through the trust, and potentially a separate tax return. This creates work and expense every year.
• Loss of access to cash value. If the policy is a permanent life insurance policy with cash value, you cannot borrow against that cash value. The trust owns the policy, not you.
• You cannot change beneficiaries. Once the trust document names the beneficiaries, you generally cannot change them. Some trusts give the trustee limited power to adjust distributions, but the beneficiaries themselves are usually fixed.

These drawbacks are significant. An ILIT is a long-term commitment that should only be undertaken with careful thought and professional guidance. Make sure the estate tax savings justify the cost, complexity, and loss of flexibility.

Who Needs an ILIT?

Not everyone needs an irrevocable life insurance trust. ILITs are designed for people with estates large enough to face federal estate taxes. If your total estate, including life insurance, is well below the federal estate tax exemption, an ILIT may not be worth the cost and effort.

Here are the people who benefit most from an ILIT.

• Individuals with estates at or above the federal estate tax exemption. The federal exemption is expected to decrease in the coming years, which means more estates could be affected.
• Business owners with large life insurance policies tied to buy-sell agreements or key person insurance.
• People who live in states with their own estate or inheritance taxes. Some states have much lower exemptions than the federal government, so an ILIT may help even if your estate is below the federal threshold.
• People who want to protect life insurance proceeds from beneficiaries' creditors, such as parents leaving money to children who have financial or legal risks.
• Married couples who want to maximize the amount they pass to heirs by using both spouses' estate tax exemptions along with life insurance trusts.

If your estate is well below the federal exemption and you do not live in a state with its own estate tax, an ILIT is probably unnecessary. The costs and complexity may outweigh the benefits for smaller estates.

How to Set Up an ILIT

Setting up an ILIT requires careful planning and professional help. Here is an overview of the process.

• Hire an estate planning attorney. This is not a do-it-yourself project. You need an attorney experienced with ILITs and estate tax law. The trust document must be drafted correctly to achieve the desired tax benefits.
• Choose your trustee. The trustee manages the trust and pays the premiums. You should not serve as trustee of your own ILIT because it could give the IRS reason to include the policy in your estate. Choose a trusted family member, friend, or professional trustee.
• Decide on beneficiaries and distribution terms. Determine who will receive the death benefit and how it will be distributed. Will it be a lump sum or spread over time? Will there be conditions? These details go into the trust document.
• Obtain a tax identification number. The ILIT needs its own Employer Identification Number from the IRS. Your attorney or trustee can apply for this.
• Open a bank account for the trust. The trust needs its own bank account to receive your gifts and pay the insurance premiums.
• Apply for the life insurance policy. The trustee applies for a new policy with the trust as both the owner and beneficiary. You will need to complete a medical exam and application as the insured person.

Once the trust is established and the policy is in place, you begin the annual routine of making gifts to the trust and having the trustee send Crummey letters and pay premiums. Work closely with your attorney and financial advisor to make sure everything is done correctly each year.

Choosing the Right Trustee

The trustee plays a critical role in managing your ILIT. Choosing the right trustee is one of the most important decisions you will make when setting up the trust.

You should not serve as the trustee of your own ILIT. If you retain too much control over the trust or the policy, the IRS may argue that you still own the policy. This could include the death benefit in your taxable estate, defeating the entire purpose of the trust.

Here are common trustee options.

• A trusted family member or friend. This is the most common choice for smaller ILITs. The person should be responsible, organized, and willing to handle the administrative duties. There is usually no fee for a family member serving as trustee.
• A corporate or professional trustee. Banks, trust companies, and financial institutions can serve as trustee. They have expertise in trust administration and ensure all legal requirements are met. Professional trustees charge an annual fee, typically a percentage of the trust assets.
• A combination approach. Some people name a family member as trustee and a professional advisor as a co-trustee or advisor to the trustee. This combines personal knowledge with professional expertise.

Whoever you choose as trustee, make sure they understand their responsibilities. They must send Crummey letters on time, pay premiums when due, and keep accurate records. Failure to perform these duties correctly can jeopardize the tax benefits of the trust.

ILITs vs. Other Types of Trusts

An ILIT is one of many types of trusts used in estate planning. Understanding how it compares to other trusts can help you decide if it is the right tool for your needs.

• ILIT vs. revocable living trust. A revocable living trust lets you maintain control and make changes during your lifetime. However, assets in a revocable trust are included in your taxable estate. An ILIT removes the life insurance from your estate but cannot be changed. They serve different purposes and many people have both.
• ILIT vs. bypass trust. A bypass trust, also called a credit shelter trust, uses the deceased spouse's estate tax exemption to shelter assets from estate tax. An ILIT specifically targets life insurance. These trusts can work together in a comprehensive estate plan.
• ILIT vs. charitable remainder trust. A charitable remainder trust provides income to you during your lifetime and then donates the remaining assets to charity. An ILIT provides a death benefit to your heirs. They have completely different purposes.
• ILIT vs. dynasty trust. A dynasty trust is designed to pass wealth across multiple generations while minimizing transfer taxes. An ILIT can be structured as a dynasty trust by including generation-skipping provisions. This is an advanced strategy that requires careful legal planning.

Your estate planning attorney can help you determine which types of trusts you need based on the size of your estate, your goals, and your family situation. Most people with large estates use multiple types of trusts together.

How Much Does It Cost to Establish and Maintain an ILIT?

The cost of an ILIT includes both upfront and ongoing expenses. Here is what you can expect to pay.

• Attorney fees for drafting the trust. Expect to pay $2,000 to $5,000 or more, depending on the complexity of your estate plan and the attorney's rates. More complex trusts with multiple beneficiaries or special provisions cost more.
• Life insurance premiums. You pay the premiums indirectly through gifts to the trust. The premium amount depends on the type and amount of life insurance. This is your largest ongoing cost.
• Trustee fees. If you use a professional trustee, expect annual fees of 0.5 to 1.5 percent of the trust assets. Family members serving as trustees often do not charge a fee.
• Tax return preparation. The ILIT may need to file its own tax return each year. An accountant typically charges $500 to $1,500 to prepare a trust tax return.
• Crummey letter administration. Sending Crummey letters each year is an administrative task. Some trustees handle this themselves. Others hire an attorney or administrator to manage it, which adds a small annual cost.

When you compare these costs to the potential estate tax savings, an ILIT can be well worth it for large estates. If your life insurance death benefit is $2 million and the estate tax rate is 40 percent, the ILIT could save $800,000 in taxes. The setup and maintenance costs are small compared to those savings.

Common Mistakes to Avoid with ILITs

ILITs are complex estate planning tools. Mistakes in setup or administration can undo the tax benefits entirely. Here are the most common errors to avoid.

• Retaining incidents of ownership. If you keep any control over the policy, such as the ability to change beneficiaries, borrow against the cash value, or cancel the policy, the IRS may include the death benefit in your estate. The trust must own and control the policy completely.
• Failing to send Crummey letters. If you do not send Crummey letters every time you make a gift to the trust, the gifts may not qualify for the annual gift tax exclusion. This can create gift tax liability and reduce the effectiveness of the trust.
• Paying premiums directly. You should never pay the life insurance premium directly to the insurance company. The correct method is to make a gift to the trust, send Crummey letters, wait for the withdrawal period to pass, and then have the trustee pay the premium from the trust account.
• Naming yourself as trustee. Serving as trustee of your own ILIT gives you control over the policy, which can cause the IRS to include the death benefit in your estate. Always choose someone else as trustee.
• Ignoring the 3-year rule. If you transfer an existing policy into the ILIT and die within three years, the entire death benefit is included in your estate. Plan for this risk or have the trust buy a new policy from the start.

Key Takeaways

An irrevocable life insurance trust is a powerful estate planning tool that removes life insurance proceeds from your taxable estate. It can save your heirs significant money in federal estate taxes, especially for large estates. The trust also provides creditor protection and gives you control over how and when beneficiaries receive the death benefit.

However, ILITs are complex and irrevocable. They require upfront legal costs, ongoing administration, and a permanent loss of control over the policy. They are best suited for people with estates large enough to face federal or state estate taxes.

If you think an ILIT might be right for you, work with an experienced estate planning attorney. They can evaluate your estate, determine whether the tax savings justify the costs, and draft a trust that meets your specific needs. Do not try to set up an ILIT on your own. The legal and tax requirements are too complex for a do-it-yourself approach.