Irrevocable Life Insurance Trusts, or ILITs, have long been a staple of estate planning, helping individuals, families and business owners meet a wide range of goals. But after the 2017 Tax Cuts and Jobs Act raised the federal estate-tax exemption limits (now $12.06 million per person and $24.12 million per couple), some people wondered whether an ILIT still made sense. After all, the logic goes, with more of your money now shielded from federal estate taxes, you may no longer need to worry about having to pay estate taxes on your insurance payouts.
The answer isn’t as clear-cut as you might assume, according to Matt Johnston, senior director of advanced planning at Northwestern Mutual. To understand why, let’s first look at how an ILIT works.
How does an irrevocable life insurance trust (ILIT) work?
An ILIT (pronounced “eye-lit”) is a type of trust that it is funded during your lifetime with one or more life insurance policies. It is irrevocable, which means that once you create an ILIT the trust generally cannot be changed or revoked; the terms of the trust agreement are pretty much set in stone.
Benefits of an irrevocable life insurance trust (ILIT)
In exchange for moving your life insurance policy into the trust, an ILIT provides certain advantages.
“For one, an ILIT can help you avoid having your policy death benefit included in your estate for federal estate tax purposes. At the same time, an ILIT gives you the ability to direct, through the trust document, how and when the death benefit is used, and for whom,” Johnston says.
Funding a trust with life insurance can also help provide the cash needed to cover estate taxes and other expenses after you die. That helps avoid having to sell a business or other high-value asset to cover those costs. Plus, “an ILIT enables you to fully leverage the annual gift tax exclusion — $16,000 per donee or beneficiary in 2022 — by using those gifts to pay the premiums on the life insurance in the trust,” Johnston says.
Risks of an irrevocable life insurance trust (ILIT)
You should also be aware of certain drawbacks to using an ILIT. One is that establishing this type of trust requires the grantor to completely give up all rights to the property in the trust, including who the trust beneficiaries are and under what circumstances and conditions they receive the assets.
“Life insurance is a very flexible asset,” Johnston explains. “As the owner of the policy, you can take some money out, often tax-free, through a partial surrender or loan. The biggest tradeoff when establishing an ILIT is the loss of your personal use of the policy. The life insurance policy goes from your personally owned asset available for your personal and retirement expenses to a trust owned asset used almost exclusively for legacy purposes.”
Another concern might be the cost. Setting up and maintaining an ILIT may require professional fees and filing a gift tax return in the year the trust is funded and possibly in future years.
Should you get an irrevocable life insurance trust?
So what role can ILITs play now, even with the current estate tax environment? Here’s what to consider if you’re weighing whether to open an ILIT.
The current estate tax laws are set to revert
The new federal estate tax exemptions are temporary. Unless the laws are changed, these higher limits will sunset and revert back to prior limits ($5 million for individuals and $10 million for couples, inflation adjusted) beginning in 2026. Individuals with rapidly appreciating property or a growing business may want to consider “taking advantage of these higher limits by creating a new trust or adding to an existing one before the limits are halved,” Johnston suggests.
You may still have a state estate tax problem
The federal estate tax isn’t the only concern for many affluent Americans; some states levy their own separate estate tax. The life insurance death benefit within an ILIT can provide the funds to cover those taxes and other expenses.
“In many states with an estate tax, the state estate tax exemption is lower than the federal exemption,” Johnston says. “If you live in a state with a state estate tax, an ILIT is a very common estate planning solution.”
ILITs provide protection beyond taxes
An ILIT provides a number of advantages beyond the ability to provide a tax-free death benefit. This includes protecting your insurance benefits from divorce, creditors and legal action against you and your beneficiaries. An ILIT also avoids probate and shields assets from expense and loss of privacy during probate.
“An ILIT can be used to protect an inheritance for a minor child, a loved one with special needs or an adult child who lacks the maturity or financial savvy to handle a large sum of money,” Johnston says. “It can also provide liquidity to fund a business succession plan or to avoid having to sell an illiquid asset, such as a family business, farm, or a home. It can also help equalize inheritance among multiple beneficiaries or provide liquidity to pay taxes or make charitable bequests.”
Of course, no one knows for certain what the future will bring for estate taxes and exemptions. Nonetheless, an ILIT can provide you, your loved ones and your estate with significant benefits. To determine if an ILIT makes sense for your needs and goals, and to leverage the opportunities offered by the higher federal estate exemption amount, it’s important to review your estate plan with your financial and legal advisors, as well as your tax professional, today.
“Regardless of taxes, you may want a life insurance policy in an ILIT to give you assurance that your beneficiaries are taken care of after you are gone,” Johnston says. “You get peace of mind knowing that you have a plan in place to leave a certain amount of money in an ILIT for your beneficiaries. Then you have the mental freedom to spend your remaining assets.”
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