What is it?
An ILIT is an unmodifiable trust with a life insurance policy as its key asset. The trust appears as the insurance policy owner and beneficiary although it is not a person. The trust pays all of the life insurance policy’s premiums. When the person named in the policy dies, the death benefit pays to the trust. The trust pays the trust’s beneficiaries. While this may seem to simply add a step to the life insurance process, it results in asset protection for the person named in the policy while alive and the trust beneficiaries, typically the family of the person named in the policy. It also prevents potential estate taxation.
Who Needs an Irrevocable Life Insurance Trust?
C-level employees can find ILIT’s handy for providing significant, tax exempt awards to their family members in their death. The 2019 estate tax exemption limit is $11.4 million. That means if a CEO leaves $11.3 million to their spouse, for example, it remains tax exempt under the current estate laws. However, if the CEO leaves $11.6 million to their spouse, the entire amount incurs taxes. It is not a protection to break those awards down into smaller amounts. For example, leaving $5 million to a child and $6.5 million to the spouse incurs the tax penalty, too, because it is cumulative. It reflects the estate’s amount, not the award amounts.
An ILIT allows an individual to purchase a life insurance policy in any amount and protect it in a trust. Regardless of the amount of the death benefit, the full amount goes to the trust beneficiaries without taxation. The same $11.6 million death benefit to a spouse coming from an ILIT incurs zero taxation.
Common Pitfalls to an ILIT
It is worth noting that there are some common pitfalls to an Irrevocable Life Insurance Trust that you should be aware of. Trustees do not do Crummey letters. The beneficiary of the trust has the ability to withdraw the gift into the trust, and the Crummey letter informs them of their ability to do so. If the trustee fails to send the letter, it could mean the ILIT gets ‘clawed back’ into the estate.
Benefits of an ILIT
While life insurance typically is not taxable, it does contribute to the overall estate value. That means you might have savings, retirement and investments equaling about $6 million. You might have thought ahead and purchased life insurance to match that… another $6 million. If you had not read this or conferred with your financial planner, you would not know that you need to place that life insurance policy in an ILIT to protect it and to ensure that your matching policy does not drive your total estate about the taxation threshold.
Opening an ILIT provides your employees one way of reducing the size of their taxable estate and further protecting their loved ones. It also protects their policy from creditors. An individual can move an existing policy or a new policy into an ILIT. The only downside to this is the irrevocable nature. Once the policy and trust are created, you cannot change them. That means you cannot add a late life child or a second spouse to the policy or trust. You would need a second, separate trust.