By Phil West, WCI Contributor
Some people have enough wealth to be concerned with how the estate tax will affect their fortune once they die. There’s a tool available that allows someone to set money aside, exempting it from taxes and directing it to go directly to beneficiaries as that person sees fit. But once a person decides to make that leap, they can’t undo that decision. That's the “irrevocable” part of what’s known as an irrevocable life insurance trust.
What Is an Irrevocable Life Insurance Trust?
An irrevocable life insurance trust is a type of trust that can, if you set it up correctly, protect your assets, help with your estate planning, and help minimize taxes.
Unfortunately, it comes with a very big caveat. That caveat is that it is irrevocable. That means once you put assets into it, they are no longer yours and are governed by the rules of the trust. But there are times when you still might want to use it.
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What Is the Purpose of an Irrevocable Life Insurance Trust and How Do They Work?
You have substantial assets. You're 100% positive you're not going to need them to provide financial support for you during your life. You're worried creditors might get them, and you're also concerned about exceeding the estate tax exemption (which, in 2023, is $12.92 million for an individual and $25.84 million for a married couple).
What you can do is put the assets into an irrevocable trust while you're still alive. Anything you put in the trust is protected from your creditors because it isn't yours anymore. Remember the gift tax laws allow you and your spouse to “gift” up to $17,000 each per year  to anyone or anything you like without invoking “gift taxes,” which then creates a reduction in your $25.84 million exemption.
Working together, you and your spouse can put a total of $34,000 a year into the irrevocable trust without reducing your exemption useable at death. If you do this every year for a decade or two before you die, you can substantially reduce the amount of your estate at death, perhaps even to the point where the estate won't owe estate taxes at all.
Who Can Be a Trustee of an Irrevocable Life Insurance Trust?
The trustee can be anyone the grantor trusts to oversee the trust, and that person makes sure that beneficiaries are taken care of per the terms of the trust. Since it’s tied to life insurance and isn’t paid out until the grantor dies, it’s a good idea to entrust someone who will be alive and able to execute the duties of a trustee.
Who Is the Beneficiary of an Irrevocable Life Insurance Trust?
As with the selection of the trustee, the beneficiary or beneficiaries of this type of trust are completely dependent on the wishes of the person setting up the trust. There are certain legal considerations to factor in when determining who’s included as a beneficiary and how much each person should get.
“A properly drafted ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries. To avoid gift taxes, it is crucial that the trustee, using a Crummey letter, notify the beneficiaries of the trust of their right to withdraw a share of the contributions for a 30-day period. After 30 days, the trustee can then use the contributions to pay the insurance policy premium. The Crummey letter qualifies the transfer for the annual gift tax exclusion by making the gift a present rather than future interest, thus avoiding the need in most cases to file a gift tax return.”
Note that once a beneficiary is named, it can be challenging to remove that person as a beneficiary. That includes someone who is your spouse at the time your trust is set up but who becomes your ex-spouse before you die.
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Benefits of an Irrevocable Life Insurance Trust
The most obvious benefit of an irrevocable life insurance trust is the trust aspect. The money is technically not yours, moving from your control to the trust’s. You still maintain oversight as to where it goes once you die, and it won’t be taxed (or accessible to any creditors) while you’re alive.
How to Set Up an Irrevocable Life Insurance Trust
Working with a lawyer and a financial advisor is probably a good idea.
If you already work with a lawyer and a financial advisor and trust them with your other financial planning requirements, you should be set here. Some life insurance companies can help you create an ILIT as well. But definitely shop around and seek recommendations if you’re looking to use the services of new advisors for something so important and—again, this word—irrevocable.
Are Irrevocable Life Insurance Trusts Taxable?
Life insurance proceeds are income tax-free. They are not, however, estate tax-free. If your estate is $12 million and you also have a $2 million life insurance policy, you'll owe estate taxes on a little more than $1 million upon your death—unless it is left to your spouse, which just delays the issue. One way to get around this issue is to put the policy inside the irrevocable trust. In fact, many people actually start a trust and then have the trust buy the policy on you. Since it is a policy that you want in force at the time of your death—not just for a specific period of time or term—you would buy a permanent life insurance policy, such as whole life. Keep in mind that whole life insurance usually isn't a very good investment, but for the right person, it can have HUGE tax advantages with regard to the estate tax.
What people do is buy as big of a whole life policy as they can for their age and health for a premium of up to $26,000 a year. They also often buy “second to die” type policies that only pay when the widow or widower (aka the surviving spouse) from a married couple dies. This allows for a larger benefit and/or a lower premium to maximize the benefit.
Upon the death of the second spouse, the trust receives the proceeds of the policy, which is then distributed to the heirs in accordance with the rules of the trust—free of both income tax and estate tax. Now, it sounds great to avoid all those taxes. But trusts have expenses, as do life insurance policies—especially permanent life insurance policies. So while this isn't a good idea for everyone, it can be a great idea for those whose estates exceed the current estate tax exemption limit.
One strategy is to use a credit shelter trust to get the full exemption and then use gifts to an irrevocable life insurance trust to keep the estate under $12.92 million. Remember this, though. Unless Congress acts, that exemption is likely to fall significantly in 2026, and that estate tax limit of $12.92 million/$25.84 million could be cut in half.
Tax Consequences of Terminating an Irrevocable Trust
A Yahoo Finance article notes, “When assets held within the trust are liquidated and distributed to beneficiaries, those transactions may trigger a combination of income and capital gains taxes.” If there’s a grantor attached to the trust, “the person who created the trust is considered the owner of the assets and is responsible for the taxes.”
In addition to the income and capital gains tax hits that could be incurred from ending the trust, there could also be estate tax implications, depending on how much money was in the trust and what it adds to the estate. If it gets the estate over the $12.92 million or $25.84 million thresholds, it’s subjecting the estate to estate taxes.
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Who Should Use an Irrevocable Life Insurance Trust?
If you have a lot of wealth, if you feel resolute about who your beneficiaries should be, and if you feel secure in parting with a portion of your fortune for estate tax relief, an ILIT can be a powerful tool that leaves more of your estate to your loved ones and less of it to Uncle Sam. But if you have concerns about any aspects of this, it’s worth thinking about—and consulting with legal and financial advisors you trust—before you commit.
Have more questions about estate planning or protecting your assets? Hire a WCI-vetted professional to help you sort it out.
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