For high-net-worth individuals and families looking to create a tax-efficient source of liquidity outside their estate, the irrevocable life insurance trust (ILIT) remains an effective and time-tested strategy. But success lies in the details – how the trust is structured, how it is funded and how it is managed.
What is an ILIT?
An ILIT is a type of irrevocable trust designed to be the owner and beneficiary of one or more life insurance policies. It is typically established by one insured individual - or two insureds under a joint-and-survivor policy - who either transfers an existing policy into the trust or has the trust purchase a new policy. During the insured’s lifetime, the ILIT trustee holds all powers to manage each life insurance policy and pays premiums based on contributions from the insureds. Upon the death of the insured, the trustee collects the death benefit and distributes the proceeds according to the terms of the trust - outside of the taxable estate.
Why Use an ILIT?
While properly structured life insurance is not subject to income tax at the death of the insured, such protection does not always extend to state and federal estate and death taxes. An ILIT, by its nature as an irrevocable trust, can substantially reduce tax exposure while also providing protected liquidity for heirs and beneficiaries. Key benefits include:
- Protection from creditors: While life insurance death benefits are often protected from claims against the insured, these protections do not apply to claims against individual beneficiaries. An ILIT can enhance creditor protection for beneficiaries.
- Tax Efficiency: When properly structured, ILITs can keep death benefits out of the taxable estate, while creating an external pool of liquidity to cover estate taxes or debts without needing to sell illiquid assets. This can be helpful for clients with private businesses, real estate holdings, collectibles, and other high-value illiquid assets.
- Legacy Planning: ILITs can support broader estate planning goals, enhancing opportunities to diversify investments across multiple trusts or replacing wealth for charitable giving.
- Return on Investment: A properly structured ILIT can create a substantial return on investment, when comparing total premiums paid to the death benefit ultimately received.
- Simpler Setup and Lower Costs: An ILIT can be easier to establish and maintain when compared to other more complex irrevocable trusts, such as SLATs, GRATs, and QPRTs, and can be used to support the functions of these trusts. Establishing the ILIT in a trust-friendly jurisdiction like South Dakota - which offers the lowest premium tax rate in the U.S. - can further enhance benefits.
Key Considerations When Establishing an ILIT
- Trustee Selection: The insured cannot serve as trustee. A professional trustee can simplify administration, improve compliance, and strengthen creditor and tax protections.
- Gift Tax Implications: ILITs must acquire a new or existing policy, and must have sufficient funds to pay annual premiums directly. This can require an upfront gift of a policy or cash, along with ongoing annual contributions to the trust. Premium payments made to the ILIT are considered gifts and may require use of your annual or lifetime gift tax exclusions. Careful coordination with a professional advisor is key.
- Policy Selection: The ILIT can be set up with a term or a permanent policy. Based on the chosen policy, there may be a cost difference in annual premiums, as well as a risk associated to the expiration of a term policy without conversion or replacement. Working with a professional advisor can help ensure that the ILIT is correctly structured to match the policy type.
- Irrevocability: Once established, ILITs are irrevocable. As the insured cannot serve as trustee nor be named as a beneficiary, they cannot access the policy’s cash surrender value, policy dividends, and policy loans for each life insurance policy added to the ILIT. However, a spouse may be included as a beneficiary.
- Cooling Period: If an existing policy is contributed to the trust, the estate tax benefits may be lost if the insured dies within three years of this initial contribution. Having the ILIT purchase a new policy can help avoid this pitfall, however the ILIT must be structured correctly for income tax purposes and have sufficient cash flow or contributions to support this purchase. A professional can provide the guidance needed.
- Annual Compliance: To maintain the ILIT’s estate tax protections, regular trust maintenance is needed, including contributions to the trust, documentation of transfers, letters to beneficiaries, and gift tax filings. Working with a professional trustee can help the insured stay up-to-date with these requirements.
- Trust Administration: Proper trust administration is essential, both before and after the death of the insured. This may include annual trust income tax returns, trust accounting, and coordination with other estate planning structures and fiduciaries.
How We Can Help
An ILIT can be a simple solution with powerful results, but it must be structured and administered correctly. Whether you are exploring your options or reviewing an existing trust, our team is here to help. Reach out to your usual Trident Trust representative or get in touch with Pete Randazzo at prandazzo@tridenttrust.com, head of our South Dakota office.