What Is an Irrevocable Life Insurance Trust and Do You Need One?

Death and taxes may be certainties of life, but how much tax your family pays upon your death is still within your control to a certain degree.

The federal estate tax exemption under current law is $12.06 million for individuals and $24.12 for married couples starting in 2022, up from $11.7 million for individuals and $23.4 million for married couples in 2021. With exemptions at the highest they've ever been, most people don't need to be concerned about federal estate taxes, with one glaring caveat.

The current law will sunset in 2025 and revert to the old law, resulting in the exemption being "basically cut in half," says Ray Radigan, senior managing director and regional trust team lead at First Republic Private Wealth Management. President Joe Biden has also vocalized a plan to reduce the lifetime exemption to as low as $3.5 million.

So to say there is no need for asset protection would be an oversight. Like insurance, tax shelters can still be worth putting in place, even if tax laws change in your favor.

One asset protection strategy is an irrevocable life insurance trust, or ILIT. Here's what to know about this financial product.

What Is an Irrevocable Life Insurance Trust?

"An irrevocable life insurance trust is a type of trust that is specifically designed to hold a life insurance policy, so the proceeds of the policy avoid estate tax," says Jason Field, financial advisor at Van Leeuwen & Company. It is a form of living trust that cannot be dissolved or revoked unless failure to pay premiums causes the insurance policy held by the trust to lapse.

"The main advantages of an ILIT are that it can provide immediate liquidity to beneficiaries, and those proceeds are tax-free," says Nick Hatfield, vice president and wealth advisor at EP Wealth Advisors. "Additionally, the value of the ILIT is outside of the estate and not subject to taxable estate calculation."

A key feature of an irrevocable trust is that it transfers ownership of the life insurance policy from the insured to the trust. For this to work properly, the insured cannot own or control the insurance policy.

Instead, "the policy is bought with the ILIT as the owner and the beneficiary, and the grantor being the insured," says Loreen Gilbert, CEO and founder of WealthWise Financial Services. The insured also cannot be the trustee of the trust. Usually, the trustee is a family member, with the insurance premiums being paid through annual gifting from the insured to the trust, she says.

If all goes as planned, upon the insured's death, the ILIT will distribute the life insurance proceeds tax-free to the beneficiaries.

To illustrate this with an example: Suppose you have assets worth $15 million and purchase a life insurance policy that pays a $5 million death benefit to your children. When you die, you would have a taxable estate of $20 million, which in 2022, would incur about $3.1 million in federal estate taxes.

If that $5 million insurance policy were owned by an ILIT instead of your client, the taxable estate would be $15 million, reducing the federal estate taxes in 2022 to about $2 million.

But what if the estate tax exemption goes down before you die? If this happens, no harm, no foul: "If the estate tax exemption goes down, and (you have) already funded an ILIT, that asset is safe from estate taxes," Gilbert says.

Those assets are also safe from your beneficiary's creditors as long as they remain in the trust.

What You Need to Know About ILITs

ILITs are not without their drawbacks, perhaps the biggest being their complexity. The challenge with ILITs is to structure them in a way that the annual contributions, which cover the insurance premiums, qualify for the gift tax exclusion, which is rising to $16,000 in 2022, up from $15,000.

To do this, "attorneys will often include what is called a Crummey power when drafting an ILIT," says Brian Bruggeman, vice president and director of financial planning at Baker Boyer Bank. The Crummey power allows you, the insured, to pay the trust for the premium on your insurance policy without reducing your lifetime gift tax exemption amount, but it also means beneficiaries must understand the purpose of the ILIT, so they don't inadvertently run afoul of any rules.

Likewise, whenever a contribution is made, Crummey letters must be sent to the beneficiaries "letting them know of the gift to the trust and that they have the right to withdraw the money," Gilbert says. If the beneficiaries then take the money out, the insurance policy could collapse.

This points to another drawback, namely that the insurance premiums for the policy must continue to be paid until death; otherwise, the policy could lapse, causing the trust to dissolve, Field says.

You must be committed to keeping the policy over a long period. "The cost of insurance associated with a permanent life insurance policy generally rises over time, so to keep the policy from lapsing, (you) need to be able to fund the policy appropriately," Bruggeman says.

And even though you are the one paying the premiums, you will have no control over the life insurance policy, meaning you can't change or designate a beneficiary or increase or decrease the policy.

Age is another consideration.

"There is a three-year lookback for existing insurance policies that are given into the ILIT, so the grantor must be alive for three years after the insurance policy is given to the ILIT for it to remain outside the estate," Gilbert says. This does not apply to a new policy established in the ILIT and does not apply if the ILIT purchases the policy from the grantor.

Having the trust purchase the life insurance policy for the policy's interpolated terminal reserve, a fancy way of saying the policy's fair value, can be one way to avoid both the three-year rule and reduce your lifetime taxable gift exclusion, Bruggeman says.

When to Use an ILIT

Given these complexities and potential drawbacks, the question becomes: Are ILITs ever worth the effort? The answer is still a qualified yes. Here are the situations when you may want to use an ILIT:

Why You Should Talk to Your Advisor About ILIT

An ILIT can be an effective means of transferring your wealth and saving your beneficiaries from estate taxes. While the estate tax exemption is at an all-time high currently, this could change in the near future, making ILITs a potentially important estate planning tool for investors of many wealth levels.

But ILITs are also complex and must be drafted with care. Remember that the trust is irrevocable, so once the terms are established, they cannot be changed. For this reason, you should work closely with your advisor to ensure the trust is administered correctly to maximize the benefit and minimize any risk, Radigan says.