An Irrevocable Life Insurance Trust (ILIT) is an estate planning tool designed to remove the proceeds of a life insurance policy from your taxable estate, potentially saving your heirs significant estate taxes and providing for efficient wealth transfer.
Can an ILIT really save my family money on estate taxes?
Absolutely. Currently, the federal estate tax exemption is quite high – over $13.61 million in 2024 – meaning only estates exceeding that amount are subject to federal estate tax. However, state estate tax thresholds are often much lower, and this federal exemption is set to revert to approximately $6.8 million in 2026 unless Congress acts. Life insurance proceeds are generally included in your taxable estate if you own the policy at the time of your death. An ILIT, when properly structured, owns the policy, effectively removing the death benefit from your estate. Consider this: a $2 million life insurance policy included in your estate could be subject to estate taxes ranging from 18% to 40% depending on your state and federal tax bracket, potentially leaving your heirs with significantly less than expected. Estimates show that approximately 1% of deaths in the US result in estates large enough to be subject to federal estate tax, but this number is higher when factoring in state estate taxes.
How does an ILIT actually work in practice?
Establishing an ILIT involves several key steps. First, the trust document is drafted, outlining the beneficiaries, trustee, and terms of the trust. You then transfer ownership of an existing life insurance policy—or purchase a new one—to the ILIT. Crucially, you relinquish *all* incidents of ownership. This means you can’t change beneficiaries, borrow against the policy, or cancel it. The ILIT, through the trustee, pays the life insurance premiums. To avoid gift tax implications when funding the trust (as the premium payments are considered gifts), the trust must utilize the annual gift tax exclusion—currently $18,000 per individual beneficiary in 2024—or employ other gift-splitting strategies. The trustee manages the trust assets and distributes them according to the trust’s terms after your death. The funds are held for the benefit of the designated beneficiaries and can be structured to provide income, pay for education, or fulfill other specific needs.
I once worked with a client, Robert, a successful software engineer, who built a considerable estate. He had a $5 million life insurance policy intending to provide for his two young children. He hadn’t considered estate tax implications. After his passing, his estate was subject to significant taxes, reducing the inheritance his children received by nearly $800,000. Had he established an ILIT earlier, that money could have remained within the family, providing a stronger financial future for his children. It was a difficult lesson learned, and his family regretted not seeking professional estate planning advice sooner.
What happens if I try to maintain control of the life insurance policy after creating an ILIT?
This is where things can go terribly wrong. If the IRS determines you retain any “incidents of ownership” – meaning you have the ability to control the policy in any way – the IRS can disregard the ILIT and include the death benefit in your taxable estate. This defeats the entire purpose of the trust. A classic mistake is continuing to pay the premiums directly, or having the policy benefits payable to your estate. One client, Susan, established an ILIT, but continued to pay the premiums using her personal bank account. The IRS successfully argued that this constituted retained control, and the life insurance proceeds were included in her estate. This oversight cost her family a substantial sum in estate taxes. It’s vital to adhere strictly to the trust terms and avoid any actions that suggest continued ownership.
Can an ILIT offer benefits beyond just estate tax savings?
Yes, absolutely. While estate tax savings are the primary goal, ILITs can also provide valuable asset protection and creditor protection for the beneficiaries. The trust structure separates the assets from individual ownership, making them less vulnerable to lawsuits or creditors. Additionally, an ILIT can ensure that the life insurance proceeds are managed responsibly for the benefit of the beneficiaries, preventing impulsive spending or mismanagement. I recall working with a client, David, whose son had struggled with financial responsibility. David established an ILIT with a spendthrift clause, protecting the proceeds from his son’s creditors and ensuring they were distributed over time for specific purposes like education and healthcare. This gave David peace of mind knowing his son would be financially secure, even with his past challenges. An ILIT, when properly structured, can be a powerful tool for protecting your family’s financial future.
“The best time to plant a tree was 20 years ago. The second best time is now.” – Chinese Proverb. This rings true for estate planning. It’s never too late to take steps to protect your family’s future.
Who Is Ted Cook at Point Loma Estate Planning Law, APC.:
Point Loma Estate Planning Law, APC.2305 Historic Decatur Rd Suite 100, San Diego CA. 92106
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