An irrevocable life insurance trust reduces your taxable estate. It is used to keep a life insurance death benefit from affecting the amount your heirs will owe in estate taxes.  

When you buy life insurance, you arrange for beneficiaries to receive a sum of money called a death benefit when you die. These proceeds generally are not taxable, but they are included in the value of your estate. If your estate is large enough at death, your beneficiaries will owe estate taxes, potentially reducing their inheritance.

Wealthy individuals with large estates may want to establish an irrevocable life insurance trust (ILIT) to reduce their taxable estate. ILITs hold your life insurance policy, pay premiums on your behalf, and entirely avoid estate taxes and probate. They can even help ensure the money is spent according to your wishes.

 

Life Insurance and Estate Taxes

When your named beneficiary receives a life insurance death benefit, they generally will not have to pay income tax or use it to settle the estate's debts. However, the death benefit is included in the deceased person's estate value for estate tax purposes. If your estate exceeds the exemption limit ($12.92 million for individuals or $24.84 million for married couples in 2023), federal estate tax is owed on the amount above that threshold. If you retain any "incidents of ownership" over your policy, the dollar amount of the death benefit—whether paid as a lump sum or an annuity—can increase your taxable estate or push its value above the exemption limit. According to the IRS, examples of incidents of ownership include:

• Having the ability to change life insurance beneficiaries
• Owning the insurance policy
• Having the ability to borrow against the policy, as with cash value life insurance
• Acting as trustee or co-trustee of a trust that holds your life insurance
• An ILIT is one way to keep the death benefit from contributing to your estate's value. Life insurance trusts help you avoid "incidents of ownership" because the policy becomes the trust's property and is no longer considered an asset held by the policyholder.

How an ILIT Works

In estate planning, a trust is a separate entity that holds assets such as money, real estate, and personal belongings, which can eventually pass to your heirs. An ILIT is an irrevocable trust that holds your life insurance policy instead of you, keeping it out of your taxable estate. The trust acts as policyholder, removing your "incidents of ownership." The death benefit is no longer part of your estate and does not increase its value for tax purposes. It also avoids probate, the legal process of administering an estate. Your heirs can receive the full death benefit. Here is how the ILIT process works:

• You establish an irrevocable trust that can never be changed.
• You transfer existing life insurance to the trust, or have the trust "buy" a new policy, then fund the trust so it can pay premiums on your behalf.
• When you die, the policy pays the death benefit to the trust, which is the life insurance beneficiary. The benefit is excluded from your taxable estate.
• The ILIT distributes the death benefit to your trust's beneficiaries according to your wishes, as outlined in the trust document.
• One provision to remember is the IRS's three-year lookback period. If you die within three years of transferring the policy to the trust, the benefit still counts as part of your estate.
• Also, if you use a permanent life insurance policy, avoid contributing more than the federal limit to its cash value. Otherwise, the IRS will treat your policy as a modified endowment contract and tax it at a higher rate.

 

Crummey Powers

When you fund the trust, the money transferred for premium payments is considered a gift and is subject to IRS gift tax. However, you can avoid gift tax on up to $15,000 in annual gifts by adding "Crummey powers"* to your trust. These give beneficiaries the ability to withdraw a limited amount of trust contributions within a certain period. They do not have to make withdrawals, but they have the option. How to Set Up an ILIT ILITs are complex and have many tax implications. It is essential to consult an attorney when setting up a trust to ensure it is implemented correctly and works to your benefit. Once you begin, you will need to make several key designations:

• The grantor: the insured person whose death triggers payment of the death benefit.
• The trustee: the trust's administrator, who cannot be the grantor.
• The trust beneficiaries: the recipients of the trust's funds.
• Establishing the trust involves these steps:
• Open and fund the trust.
• Fund the trust to maintain life insurance premium payments.
• Select a trustee.

Buy or transfer a life insurance policy. Specify how the trust will distribute the death benefit to beneficiaries. These instructions are irrevocable and cannot be changed later. How to Put Life Insurance in the Trust If you do not yet have life insurance, you can buy a policy through the trustee. You are the insured, and the trust is the policyholder. The trust—not you—must pay the premiums. If you already have a policy, you can transfer it to the trust using a change-of-ownership form. Contact your insurer to make the ILIT your policy's owner. Remember that, because of the IRS lookback period, a life insurance trust must be established at least three years before your death to successfully obtain its tax benefits. Who Should Have an ILIT? The main reason to establish an ILIT is to reduce your taxable estate, but you will not owe federal estate tax in the first place unless you exceed the $12.06 million limit (although some states impose their own estate taxes with lower exemption limits). Another important benefit is that creditors cannot claim funds held in a trust. For this reason, ILITs are best suited to high-net-worth individuals who want to avoid unnecessary exposure to higher estate taxes. Parents who want the proceeds to benefit minor children can also use an ILIT to ensure the benefit is spent on their children's care instead of being tied up in court. Most people will not need the complexity of an ILIT in their end-of-life planning for expenses such as a funeral or cremation. Combining their insurance policy with a solid will and a revocable trust will be enough for their estate plan. Because the trust cannot be changed once established, it is best for people with specialized estate planning needs. References  

• Crummey powers are named after Clifford Crummey, a wealthy grantor who wanted to create a trust fund for his children in the 1960s while retaining annual tax-exemption benefits. When a donor contributes to an irrevocable trust, beneficiaries must be notified that the money can be withdrawn within a specified period of at least 30 days.

1. Ninth Circuit Court of Appeals. " D. Clifford Crummey v. Commissioner of Internal Revenue, 397 F.2d 82 (9th Cir. 1968) ".