Life Insurance Proceeds: Irrevocable Trust Reporting

Life insurance is a crucial financial planning tool that can protect your loved ones and provide peace of mind. One way to optimise your life insurance is to place it in a trust, which can shield your assets from estate taxes. There are two types of life insurance trusts: revocable and irrevocable. This article will focus on the irrevocable life insurance trust (ILIT) and explore whether life insurance proceeds are reported on this type of trust.

Estate tax exemption

An irrevocable life insurance trust (ILIT) is a powerful tool for estate planning and can be used to minimise estate taxes. Estate taxes can consume up to 55% of an individual's life insurance proceeds, so the primary goal of a life insurance trust is to reduce or eliminate these taxes.

An ILIT is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy. The trust can also manage and distribute the proceeds that are paid out upon the insured's death, according to their wishes.

The benefits of an ILIT include:

• Minimising estate taxes: When a life insurance policy is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and are thus not subject to state and federal estate taxation.
• Avoiding gift taxes: Contributions by the grantor are considered gifts to the beneficiaries, and so are exempt from gift tax.
• Protecting government benefits: The trustee can carefully control how distributions from the trust are used so as not to interfere with the beneficiary's eligibility to receive government benefits.
• Providing liquidity: An ILIT can provide liquidity to an estate, helping to pay estate taxes, debts, and expenses.
• Avoiding probate: ILITs are not subject to the public probate process, adding privacy to an estate settlement.

The main downside of an ILIT is that it cannot be altered or undone after it is created. Whatever is put into the trust is no longer the grantor's, and changes cannot be made once the trust is finalised.

To summarise, an ILIT is a valuable tool for estate planning, particularly for those with large estates, as it can help to minimise estate taxes and protect assets. However, it is important to carefully consider the implications of setting up an ILIT, as it cannot be changed once it is finalised.

Avoiding gift tax

An irrevocable life insurance trust (ILIT) is a powerful tool for estate planning and can be used to avoid gift taxes. Here's how:

Understanding Irrevocable Trusts

An irrevocable trust is a legal arrangement that allows for the ownership, management, and distribution of property. The person creating the trust is known as the grantor, the person overseeing the trust property is the trustee, and the person receiving the benefit of the trust property is the beneficiary. Once established, the terms of an irrevocable trust cannot be changed by the grantor. This is in contrast to a revocable trust, which allows the grantor to amend or dissolve the trust at any time.

Benefits of an Irrevocable Life Insurance Trust (ILIT)

An ILIT is specifically designed to hold a life insurance policy, with the trust owning the policy rather than the grantor. This has several benefits, including potential tax savings. By placing a life insurance policy in an ILIT, the payout goes to the trust, excluding it from the grantor's estate. This can result in significant tax savings when passing on assets to heirs.

To avoid gift taxes, it is crucial to understand the role of a trustee and how they manage distributions to beneficiaries. The trustee of an ILIT has discretionary powers and can control when beneficiaries receive the proceeds of the policy. By managing these distributions, the trustee can help the grantor avoid gift taxes.

Additionally, the trustee can use a "Crummey letter" to notify beneficiaries of their right to withdraw a share of contributions for a specified period, typically 30 days. After this period, the trustee can use the contributions to pay the insurance policy premium. This qualifies the transfer for the annual gift tax exclusion, avoiding the need to file a gift tax return in most cases.

Other Tax Benefits of an ILIT

In addition to avoiding gift taxes, an ILIT can provide other tax benefits. The proceeds from a life insurance policy owned by an ILIT are generally not subject to income or estate taxes. The ILIT can also be used to protect government benefits for beneficiaries who receive aid such as Social Security disability income or Medicaid.

Considerations for ILITs

While an ILIT can provide tax advantages, there are some considerations to keep in mind. The primary downside of an irrevocable trust is that it cannot be changed once it is finalized. Therefore, it is essential to carefully plan and seek professional guidance when considering an ILIT. Additionally, there may be tax implications if the proceeds from the life insurance policy remain in the trust after the payout.

Tax considerations

An irrevocable life insurance trust (ILIT) is a powerful tool for estate planning and can be used to manage and distribute the proceeds of a life insurance policy, according to the insured's wishes. It can also help minimize estate taxes, avoid gift taxes, and protect government benefits. Here are some key tax considerations to keep in mind:

• Estate Tax Savings: The main reason for creating an ILIT is to save on estate taxes. If the insured person dies owning the life insurance policy, the proceeds will be included in their estate and taxed. By placing the policy in an ILIT, the proceeds are excluded from the insured's estate, resulting in significant tax savings for heirs. This is especially beneficial if the estate exceeds the state's estate tax exemption threshold.
• Gift Taxes: An ILIT can help avoid gift taxes as contributions by the grantor are considered gifts to the beneficiaries. Proper structuring, such as using a Crummey letter, allows the trust to qualify for the annual gift tax exclusion. However, transferring an existing policy with a large cash value to the trust may trigger gifting issues.
• Generation-Skipping Transfer Tax (GSTT): An ILIT can help leverage the grantor's GSTT exemption. By using the trust to buy and fund a life insurance policy, proceeds from the death benefit are excluded from the grantor's estate, allowing multiple generations to benefit from the trust's assets without incurring estate or GSTT.
• Tax Identification and Income Tax: An ILIT has its own tax identification number and income tax schedule. While the cash value accumulating in a life insurance policy and the death benefit are typically tax-free, any investment income earned by the trust and not distributed to beneficiaries may be taxed.
• Spousal Benefits: If the beneficiary is a spouse, there are generally no tax liabilities on the lump-sum payout. Additionally, assets can pass estate-tax-free between spouses, regardless of the amount, as long as the spouse is a US citizen. However, when the surviving spouse passes away, any remaining proceeds in their name become subject to estate tax. An ILIT can shelter these proceeds from estate taxes.
• State-Level Estate Taxes: Even if your estate falls below the federal threshold, consider your state's estate tax laws. Some states have much lower exemption thresholds, and an ILIT can help reduce potential tax liabilities at the state level.
• Existing Policies: Transferring an existing life insurance policy to an ILIT requires careful consideration. There is typically a three-year lookback period, and if the insured dies within this period, the death benefit will be included in their estate for tax purposes. Additionally, policies with a large accumulated cash value may trigger gifting issues.
• Trustee Considerations: The trustee of an ILIT plays a crucial role in managing payouts and ensuring the grantor's wishes are followed. They are responsible for paying premiums, notifying beneficiaries, and investing or distributing proceeds. The trustee should open a separate checking account for the trust and keep detailed records for potential submission to the IRS.
• Professional Guidance: Creating an ILIT can be complex, and it's essential to seek guidance from financial, tax, and legal professionals. They can help navigate the tax implications, ensure proper structuring, and maximize the benefits of the trust for all involved parties.

Trustee selection

When setting up an irrevocable life insurance trust (ILIT), the grantor can place a life insurance policy inside the trust. This means that the trust owns the policy, not the grantor. The trustee is responsible for managing the trust and distributing the proceeds to the beneficiaries. Therefore, selecting a trustee is an important decision.

The trustee should be someone who is trustworthy and capable of carrying out the grantor's wishes. They should also have a good understanding of financial matters and be able to make sound decisions regarding the management of the trust. The trustee can be a family member, friend, or a professional such as an accountant or an attorney.

When selecting a trustee, it is important to consider their qualifications, experience, and ability to manage the trust effectively. The trustee should also be someone who is likely to outlive the grantor, as the trust will continue to exist even after the grantor's death.

In some cases, the grantor may choose to appoint co-trustees, who will work together to manage the trust. This can provide additional expertise and ensure that the trust is properly managed. The co-trustees can be family members, professionals, or a combination of both.

It is also important to consider any potential conflicts of interest when selecting a trustee. The trustee should be someone who will act in the best interests of the beneficiaries and not their own personal interests. They should also be impartial and unbiased when making decisions regarding the distribution of the proceeds.

Overall, the selection of a trustee for an irrevocable life insurance trust is a crucial decision that can impact the effectiveness of the trust. It is important to choose someone who is trustworthy, qualified, and capable of carrying out the grantor's wishes. By selecting the right trustee, the grantor can ensure that the trust is properly managed and that the beneficiaries receive the intended benefits.

Annual exclusion

An Irrevocable Life Insurance Trust (ILIT) is a powerful estate planning tool that can be used to manage and distribute life insurance proceeds, as well as reduce tax liabilities and protect assets. One of the key benefits of an ILIT is the ability to minimise estate taxes. When a life insurance policy is owned by an individual, the death benefit payout is typically included in their taxable estate, which can result in significant estate taxes. However, when the policy is owned by an ILIT, the proceeds are excluded from the insured's gross estate and are not subject to estate taxation. This can lead to significant tax savings for large estates.

To further reduce tax liabilities, an ILIT can be designed to take advantage of the annual gift tax exclusion. In 2025, an individual can give up to $19,000 per year to another person without reporting it to the Internal Revenue Service (IRS). For married couples filing jointly, this amount doubles to $38,000. By utilising the annual gift tax exclusion, individuals can transfer funds to the ILIT to cover insurance premiums without incurring gift tax consequences.

The annual gift tax exclusion amount can be maximised by considering the number of beneficiaries of the ILIT. For example, if an ILIT has four beneficiaries, a trustmaker could make a gift of $60,000 to the ILIT per year ($15,000 x 4 beneficiaries). If the trustmaker is married, they could double this amount to $120,000 per year. It is important to note that any amount gifted above the annual exclusion must be reported to the IRS using Form 709.

To ensure compliance with IRS rules, it is crucial to send a "Crummey letter" to the beneficiaries of the ILIT. This letter notifies them of their right to withdraw their share of contributions for a specified period, typically 30 days. After this period, the trustee can use the contributions to pay the insurance policy premiums. The Crummey letter qualifies the transfer for the annual gift tax exclusion by making it a present rather than a future interest.

In summary, an ILIT offers a range of benefits, including tax advantages and asset protection. By utilising the annual gift tax exclusion, individuals can effectively transfer funds to the ILIT to cover insurance premiums, further reducing their tax liabilities. It is important to work with a qualified estate planning attorney or financial professional to ensure the ILIT is properly structured and compliant with applicable laws and regulations.

Frequently asked questions