What is an irrevocable life insurance trust?

An irrevocable life insurance trust (ILIT) is an irrevocable trust structured to hold one or more life insurance policies, typically insuring the life of the grantor. The primary reason for having an ILIT own a life insurance policy is to keep the insurance proceeds out of the grantor’s estate for estate tax purposes. When a grantor owns insurance on his or her own life, the proceeds will be included in the grantor’s taxable estate; when an ILIT owns the insurance, the proceeds typically will not be included in the grantor’s taxable estate.

With an ILIT, the trustee (someone other than the insured) takes ownership of the policy and pays the premiums, usually with funds contributed to the ILIT by the grantor. Upon the death of the insured, the life insurance proceeds will be paid to the ILIT, to be held and used for the beneficiaries of the ILIT as provided in the governing trust document.

Advantages of an irrevocable life insurance trust:

Estate tax reduction: The primary benefit of an ILIT is to keep the insurance proceeds out of the insured’s estate for federal estate tax purposes. In most cases, this will mean that there is no estate tax liability associated with those proceeds.

Liquidity: Life insurance is used for many purposes, such as replacing the insured’s income after death or providing liquidity to an otherwise illiquid estate. When an ILIT collects insurance proceeds, it will often use them to make a loan to the insured grantor’s estate or to purchase illiquid assets, such as real estate or closely-held stock, from that estate. That additional liquidity may help the estate pay an estate tax liability, pay off debt, or help with estate administration expenses.

Other trust benefits: Upon the grantor’s death and once the ILIT has collected the proceeds (and, if applicable, used them to make a loan or purchase other assets), the trustee will distribute the assets remaining in the ILIT according to the terms of the trust’s governing document. Distributions can be outright to the beneficiaries or held in ongoing trusts for the beneficiaries. That type of ongoing trust can ensure that the grantor’s wishes are carried out in providing for the grantor’s chosen beneficiaries. As with other irrevocable trusts, the beneficiaries can enjoy a regular stream of income, periodic principal distributions, and potential protection from creditors.

Considerations for an irrevocable life insurance trust:

Irrevocability: An ILIT is an irrevocable trust, which means the grantor cannot easily change the terms of the trust document.

Contributions to the ILIT constitute reportable gifts: If the grantor transfers an existing policy to an ILIT, the grantor will generally be required to report the value of that gift on a federal gift tax return. In addition, if the grantor contributes cash to the ILIT to pay premiums, those contributions will generally also be treated as reportable gifts. These gifts may or may not result in a current gift tax liability. If not, they certainly may cause a reduction in the insured’s lifetime exemption from estate and gift taxes. Despite these complications, many find ILITs to be attractive because they can make relatively small gifts (the value of the premiums) to get a much larger amount (the proceeds) out of their estates.

Crummey powers: To eliminate or reduce the gift tax consequences of contributions to the ILIT, many ILITs include so-called “Crummey” powers for the beneficiaries. A Crummey power enables a beneficiary to withdraw part or all of the grantor’s contribution to the ILIT. This is used to allow those contributions to be treated as “present interest” gifts so that they can qualify for the annual exclusion from gift taxes, rather than consume a portion of the grantor’s lifetime gift exemption.

Loss of policy control and access: When a grantor transfers an existing life insurance policy to an ILIT, the grantor gives up control over the policy and can no longer take withdrawals from, or borrow against, the policy’s cash value. If the grantor wishes to drop the insurance coverage, the grantor’s primary means of doing so is to stop adding cash to the ILIT. If there is no new cash available, the trustee will have to decide whether to cash out the policy or to let it remain in place as long as it can. In some cases, the trustee can also reduce the amount of coverage, but those decisions belong to the trustee of the ILIT, not the grantor.

Three-year rule: If the grantor transfers an existing life insurance policy to an ILIT, and then passes away within three years of doing so, the life insurance proceeds may not be excluded from the grantor’s estate. With new policies, one way to avoid this is to have the ILIT apply for the policy and own it from the date it is issued.

Example of estate tax mitigation with an ILIT:

John owns a $5 million life insurance policy on his own life. Because of the other assets he owns, he knows that his estate will be subject to federal estate tax at his death. Given the top federal estate tax rate of 40%, his continued ownership of the policy could result in $2 million of additional estate tax liability at his death. To avoid this result, he transfers the policy to a newly formed ILIT.

So long as he survives for three years following the transfer, the policy proceeds should not be included in his taxable estate. Because the policy has substantial cash value at the time of the transfer, he will have to report the transfer as a gift on a federal gift tax return. On an ongoing basis, he will report the value of his annual contributions to the ILIT. Depending on the amount of those contributions and of any other gifts he makes to the beneficiaries of the ILIT, those contributions might qualify as annual exclusion gifts, or they might consume more of his lifetime exemption from estate and gift taxes.

Comprehensive estate planning strategies from Commerce Trust

While an ILIT can be an impactful estate planning tool for estate tax reduction and transferring proceeds from a life insurance policy, its efficacy depends on careful consideration of your financial goals and a thorough understanding of applicable laws. At Commerce Trust, our wealth management teams are comprised of specialists across multiple disciplines who can help you determine which estate planning strategies best support your comprehensive estate plan. If that includes establishing a trust, we will prepare you to meet with an estate planning attorney by providing holistic guidance in advance and can work closely with them on an ongoing basis to achieve your unique objectives. Contact Commerce Trust today if you want to learn more about our private wealth management and estate planning services and how we can help you incorporate a trust into your estate plan.

The opinions and other information in the commentary are provided as of August 15, 2024. This summary is intended to provide general information only, and may be of value to the reader and audience.

This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such. 

Commerce Trust does not provide tax advice to customers unless engaged to do so. Commerce Trust does not provide legal advice to its customers. Consult an attorney for legal advice, including drafting and execution of estate planning documents.

Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Commerce Trust is a division of Commerce Bank.

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