Life Insurance in an Irrevocable Trust - How Does It Work

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life insurance in an irrevocable trust

Written by Brian Greenberg
CEO / Founder & Licensed Insurance Agent

Last updated: September 14th, 2022

What Is an Irrevocable Life Insurance Trust?

An irrevocable life insurance trust (ILIT) is created to control and own a term or permanent life insurance policy while the insured is alive, as well as to manage and distribute the proceeds paid out upon the insured’s death. An ILIT can own both second-to-die life and individual insurance policies. Second-to-die policies insure two lives and pay a death benefit upon the death of a second individual.

An ILIT has numerous parties: trustees, the grantor, and beneficiaries. The grantor typically funds and creates the ILIT. Transfers or gifts made to ILIT are permanent, and the grantor gives up control to the trustee. The trustee manages the ILIT, and the beneficiaries receive the distributions.

The grantor needs to refrain from any incidental ownership in a life insurance policy, and any premium incurred should originate from a checking account owned by the ILIT.

What Are the Benefits of an ILIT?

An ILIT helps avoid having your policy death benefit included in your estate for federal tax purposes. An ILIT allows you to direct, through your trust document, when and how the death benefit is used and for whom.

Funding an asset protection trust with life insurance can also help availing cash required to cover estate taxes and other expenses after your death. This will help you avoid selling a business or any other high-value asset to help cover any costs. An ILIT allows you to fully leverage your annual gift tax exclusion by use of gifts to pay the premiums on the life insurance in the trust.

What Are the Negatives of an ILIT?

Establishing an ILIT trust requires the grantor to completely give up all rights to the property in the trust, including the trust beneficiaries and under what circumstances and conditions they receive the assets.

Life insurance is a very flexible asset. As the policy owner, you can take some money out, often tax-free, through partial surrender or loan. The biggest tradeoff when establishing an ILIT is the loss of your personal use of the policy. The insurance policy goes from your personal assets available for retirement and personal expenses to a trust-owned asset utilized almost exclusively for legacy purposes.

What Are the Components of an Irrevocable Life Insurance Trust?

  1. Trustee. For most trusts, the trustee is given considerable control and power over trust assets. Thus, determining an individual who will serve as a trustee is an essential decision the grantor has to make. To avoid the inclusion of the assets in the grantor’s estate, the grantor should not serve as a trustee. The beneficiary can serve as a trustee.
  2. Situs. The trust’s situs is the state where the trust is considered “located.” The situs of your trust can impact income taxes and the applicable jurisdiction for any potential litigation that may happen as a result of your trust. The protection available to trust assets as well as the length of time for which the trust can exist is also determined by the situs. The default situs is usually the grantor’s state of domicile. A lot of consideration ought to be given to the grantor’s objectives for the trust to determine whether choosing a different situs is more applicable.
  3. Trust Protector. Having a trust protector allows the grantor to make sure that the trust remains flexible when faced with unexpected circumstances and a change of law. The trust protector’s role is to change the terms or actions of the trust where necessary to ensure that the grantor’s original intent is met.
  4. Distributions. Distribution provisions range from fully discretionary trusts to trusts limited to an ascertainable standard.

What Are the Two Types of ILIT?

There are two types of ILITs: Funded ILIT and Unfunded ILIT. Funded ILIT is a trust funded with an insurance policy as well as additional assets that you can use to pay your premiums. In contrast, the unfunded premiums are a type of trust funded by the life insurance policy only and with no additional assets. The grantor makes contributions annually to the trust to provide the funds required to pay the premiums.

How Is an ILIT Funded?

Any transfer to an irrevocable trust for less than full consideration will be considered a gift to the trust. The annual gift tax exclusion amount enables the donor to contribute up to $16,000 to an unlimited number of recipients annually. A contribution to a trust is a present interest gift under certain conditions. These conditions apply when the beneficiary has a right to withdraw the amount of the gift from the trust, when the trust is for the exclusive benefit of a minor and meets some stipulated requirements, and when the beneficiary has the present right to trust income.

In addition to utilizing an annual gift tax exclusion to make tax-free gifts to an ILIT, you may opt to utilize the basic exclusion amount to make gifts to your trust. Alternatively, an ILIT can be funded through loans or by way of sale.

How Do Crummey Withdrawal Powers Work?

The Crummey powers give you a limited time to make withdrawals of contributions to a trust will. This is done by converting the future interest gifts into present interest gifts. This withdrawal right is usually limited to an amount equal to the current annual gift tax exclusion. If you do not exercise this right within a specified time, the Crummey power is deemed to have lapsed and the assets remain in your trust.

Is There a Difference Between an Irrevocable Trust and an ILIT?

An irrevocable trust involves any trust that the grantor cannot change or end after creation. The grantor selects a trust to limit estate taxes or shield assets from creditors. Whereas an ILIT is created to own and control a permanent life insurance policy while the insured is still alive. It also manages and distributes the proceeds paid out once the insured dies.

Can an Irrevocable Life Insurance Trust Own Other Assets?

Yes, an ILIT can own property other than life insurance. Since the grantor has very little control over the trust after it is established, funding an ILIT with assets other than life insurance is not right for everyone.

How to Create an Irrevocable Life Insurance Trust?

An ILOT is usually established by the formation of the trust, followed by the contributor assigning an existing insurance policy to the trust or the trustee buying an insurance policy directly from an insurance company. The insured retains no benefits in the trust.

Key Takeaways

ILIT is an elaborate tool that should be considered in many wealth management plans. It helps ensure that your policy is used in the best way to benefit your dependents. Even with the federal estate and gift tax exemption, it is still possible to owe estate taxes. Many states have started taxing your estate at $1 million or less.

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