Irrevocable Life Insurance Trust (ILIT) Benefits and Drawbacks

Man holds Irrevocable Life Insurance Trust ILIT policy.

Irrevocable life insurance trusts (ILITs) can be a critical component of an estate plan. They’re a tool that can help you avoid having to pay estate taxes, and ensure more is left behind for your loved ones. In this article, you’ll explore the functionality of ILITs. You’ll see how they work, their benefits and drawbacks, and what actions you can take to learn more, or begin using one yourself. 

What is an Irrevocable Life Insurance Trust (ILIT)?

An irrevocable life insurance trust (ILIT) works as a vehicle through which life insurance policyholders can transfer wealth to beneficiaries in a tax-advantaged way. ILITs are created by a policyholder when they transfer ownership of their policy over to a trust. The trust receives the death benefit payout, but distributes the proceeds to your named beneficiaries based on the terms of your trust agreement.

That said, ILITs can also be formed without a transfer of ownership. An ILIT can become the owner of a new policy with you as the insured. After your passing, the death benefit is still paid out to the trust, and the proceeds are distributed based on the terms of your trust agreement. 

The main reason people use an ILIT is to remove the value of their life insurance from their taxable estate. For those with large estates, high estate and gift taxes kick in after lifetime exclusion amounts are exceeded. As a result, your beneficiaries can end up receiving far less than you intended if the value of your policy is not placed in trust.

Furthermore, an ILIT serves a variety of other purposes. With your assets in a trust, they are offered protection from outside threats like creditors and lawsuits. Additionally, ILITs make it possible to be more specific with how the proceeds of your life insurance policy are distributed to your beneficiaries. For example, you can instruct that proceeds be paid out to beneficiaries as a stream of income rather than a lump sum. 

Please Note: Presently, the Tax Cuts and Jobs Act is set to expire at the end of 2025. As a result, starting in 2026, the federal gift and estate tax exemption will be returning to its pre-2018 level ($5,000,000 for individuals) with adjustments for inflation. So unless legislation changes, ILITs may become viable for individuals and families at a much lower wealth level.

Irrevocable Life Insurance Trust Benefits

Lower Estate Taxes: With an ILIT, your life insurance policy can be removed from your taxable estate. This can lower your estate and gift tax liability. Additionally, the proceeds paid out from the ILIT can be put towards your remaining tax liability. 

Asset Protection: By removing the value of your life insurance policy from your estate, you’re also protecting it from creditors, lawsuits, and potential actions of irresponsible family members. Additionally, ILITs can help protect less liquid assets like your property or small business. That’s because the liquid insurance proceeds can be applied to the insured’s estate and gift tax liabilities.

Customizable: Through the terms of your trust agreement, you’re offered flexibility in how the proceeds of your policy can be distributed to beneficiaries. 

Irrevocable Life Insurance Trust Drawbacks

Irrevocability: Once your policy is placed inside an ILIT you won’t be able to designate it to an alternative trust or entity in the future.

Timing Restrictions: Per the IRS regulations, if you die within 3 years of funding your ILIT with a life insurance policy, the proceeds will be included in your taxable estate. 

Costs: Creating an ILIT can be more complex. That’s because these trusts have to navigate the relevant tax, insurance, and trust laws. As a result, they often take on the expense of multiple administrative professionals like attorneys and CPAs. 

Irrevocable Life Insurance Trust FAQs

1. How Do Irrevocable Life Insurance Trust Premium Payments Work?

Premium payments for an irrevocable life insurance trust (ILIT) are usually completed by the policyholder, who gifts the premium payments to the trust. You’re able to use your annual and lifetime gift exclusions to gift the money. Then, the trustee can use the gifted funds to pay the premiums on the life insurance policy. 

2. What is the Irrevocable Life Insurance Trust 3-Year Rule?

The 3 year rule of ILITs refers to an IRS regulation. The regulation maintains that if a life insurance policy is placed inside an ILIT within three years of the policyholder’s passing, the policy’s proceeds will be included in the policyholder’s taxable estate. Put another way, your ILIT is rendered ineffective should you die inside of 3 years after funding it with your policy. 

3. Are Irrevocable Life Insurance Trusts Taxable?

ILITs are typically designed to reduce or eliminate the payment of gift and estate taxes. By putting your life insurance policy in an ILIT, you’re able to remove its value from your taxable estate. Furthermore, the proceeds paid out from your ILIT to beneficiaries are not subjected to income taxes. 

How to Set Up an Irrevocable Life Insurance Trust

Setting up an Irrevocable Life Insurance Trust (ILIT) can be a complicated process. You’ll want to work with an experienced professional like an estate planning attorney to make sure things are done correctly. Nevertheless, below, you’ll see a general step-by-step guide on how to create an ILIT:

Step 1) Select a Trustee: Appoint someone to serve as the trustee for your ILIT. This can be a trusted family member, friend, or professional. 

Step 2) Create a Trust Document: Have an estate planning attorney help you create the trust document. This will outline your trust’s terms, which include your beneficiaries, trustee, and asset distribution instructions. 

Step 3) Transfer Ownership to the Trust (If Needed): Transfer ownership of your life insurance policy to your ILIT. You’ll likely have to contact your insurance company to complete this step.

Step 4) Make a Gift to Your Trust: Gift funds to your ILIT to cover premium payments. Work with an appropriate professional to ensure such gifts are compliant with the relevant tax laws. 

Step 5) Inform Beneficiaries: You may want to inform your beneficiaries that they have been named as beneficiaries of your trust.

Step 6) Ongoing maintenance: Make sure to continuously review your ILIT. On a minimum annual basis, you’ll want to make sure your trust complies with all relevant tax legislation. 

How CW O’Conner Can Help You Further

At CW O’Conner it’s a privilege to help our clients keep their legacies intact. And the primary way we’re able to help is by ensuring you have the right estate plan in place.

Depending on your unique family situation, it may be worth looking into an irrevocable life insurance trust (ILIT). They can be a powerful tool in enabling you to leave more to your loved ones after your passing.

As a team, we’ll help you navigate the complexities of putting an ILIT into place. We’re able to work with your attorney and tax professional or recommend ones of our own. Our vetted network of industry professionals can point you in the right direction for all your estate planning needs.

If you’re ready to establish an ILIT, or have further questions on whether or not one may be right for you, please don’t hesitate to reach out. You can call us directly at 770-368-9919, or fill out a contact card, and we’ll reach out to you. 

The opinions and analysis expressed herein are based on C.W. O’Conner Wealth Advisors, Inc. research and professional experience and are expressed as of the date of this report. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice.

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    Cliff O'Conner

    Cliff is the founder and president of C.W. O'Conner Wealth Advisors, Inc. Cliff earned a Bachelor of Business Administration degree in Accounting from Georgia State University.

    Kevin O'Conner

    Kevin O'Conner is a financial planner with C.W. O'Conner Wealth Advisors, Inc. He earned a Bachelor of Business Administration degree in Business Management from Georgia College, and is a Certified Investment Management Analyst (CIMA).