Funding An Irrevocable Life Insurance Trust: Strategies And Steps

An irrevocable life insurance trust (ILIT) is a trust that cannot be amended or revoked once it has been established. It is designed to hold a life insurance policy, which is typically the trust's main asset. The benefits of an ILIT include minimising estate taxes, avoiding gift taxes, and protecting government benefits.

There are two ways to fund an ILIT: the first is to create an unfunded ILIT and supply it with assets by making a gift to the trust totalling the value of a single annual life insurance premium. The second option is to set up a funded irrevocable life insurance trust by transferring an income-producing asset to the trust and using the cash it generates to pay the life insurance premiums.

Reducing estate taxes

An irrevocable life insurance trust (ILIT) is a highly effective way to reduce or eliminate estate taxes. Estate taxes can consume up to 55% of life insurance proceeds, so an ILIT is a valuable tool for individuals with taxable estates.

An ILIT is specifically designed to hold and own life insurance policies. The settlor (or grantor) transfers their life insurance policies to the trustee, who owns and controls the policy or policies. The settlor cannot be the trustee or a beneficiary, but their children can be beneficiaries. The settlor must be prepared to give up some control, as they cannot change the beneficiaries or borrow from the policy.

The proceeds of the life insurance policy are held in trust for the benefit of the settlor's spouse, so they cannot be taxed in the spouse's estate either. Since the proceeds are outside the estate, the beneficiaries will not have to share any portion with the IRS. The trust's beneficiaries can use the proceeds to offset the taxes owed by the settlor's estate, allowing the settlor to keep assets intact for their beneficiaries.

To fund an ILIT, the grantor will make gifts equal to the life insurance policy premiums, using annual gifts or a portion of their lifetime exemption. The trustee deposits the check into the ILIT's checking account and uses the funds to purchase a permanent life insurance policy for the insured.

It is important to note that an ILIT is irrevocable, so any transfer of property to the trust cannot be transferred back without the consent of the trustee and beneficiaries. This is something to carefully consider before setting up an ILIT, as it has implications for the future.

Avoiding probate

An irrevocable life insurance trust (ILIT) is a powerful tool for avoiding probate. Here are some key points on how ILITs help in this regard:

Probate is the legal process of reviewing and validating a will. By placing assets into an ILIT, you can avoid this process and keep your affairs private. Here's how:

• Separation of Assets: The key mechanism through which ILITs avoid probate is by separating the life insurance proceeds from the rest of the estate. When the grantor passes away, the life insurance payout goes directly to the trust beneficiaries, not the estate. This means that the assets in the trust bypass probate entirely.
• Reducing Delays and Costs: Probate can be a lengthy and costly process, especially for larger estates. ILITs help your beneficiaries avoid these delays and expenses associated with probate.
• Preserving Assets: Assets held in an ILIT are protected from creditors and civil lawsuits. This ensures that your beneficiaries receive the full benefit of your life insurance policy without any deductions.
• Maintaining Eligibility for Government Benefits: ILITs can help your heirs maintain eligibility for means-tested government aid programs. Without proper planning, an inheritance could disqualify beneficiaries from certain government benefits.
• Control Over Distribution: ILITs allow you to maintain control over how the proceeds are distributed. You can appoint a trustee to manage the trust and ensure that your wishes are followed, even if your spouse or partner is incapacitated at the time of your death.

Other Benefits of ILITs:

In addition to avoiding probate, ILITs offer several other advantages:

• Estate Tax Reduction: The primary benefit of an ILIT is reducing estate taxes. By keeping life insurance proceeds out of the taxable estate, ILITs can save your beneficiaries a significant amount in taxes, which can be as high as 40% at the federal level.
• Gift Tax Savings: ILITs can also reduce gift taxes by utilizing the annual gift tax exclusion.
• Asset Protection: ILITs protect the assets within the trust from creditors' claims, civil lawsuits, and bankruptcy.
• Divorce Protection: The assets in an ILIT are typically protected in the event of a divorce since the trust, not the grantor, owns the policy.

Considerations and Drawbacks:

While ILITs offer significant benefits, there are some considerations and potential drawbacks:

• Loss of Control: Once you transfer a policy into an ILIT, you lose control over that policy. The trustee makes all decisions regarding the trust.
• Complexity: ILITs are complex instruments, and mistakes in their creation or management can negate their benefits. It's essential to work with an experienced attorney to set up and manage an ILIT properly.
• Tax Administration: As a separate tax entity, the ILIT requires annual tax filings and compliance with tax laws and regulations.
• Inflexibility: ILITs are generally permanent and cannot be changed or revoked. This means you need to be confident about your goals and plans before establishing one.

Protecting assets

Avoid Estate Taxes

ILITs are often used to reduce estate taxes, as the assets held in the trust are not taxable. By placing your life insurance policy inside an ILIT, you can exclude the death benefit from your gross estate, thereby avoiding federal and state estate taxes. This is especially beneficial for large estates, as it can lead to significant tax savings when passing on assets to heirs.

Protect Against Irresponsible Spending

An ILIT can help protect assets from fiscally irresponsible beneficiaries. If you have beneficiaries who are minors or adults with a history of reckless spending, an ILIT can ensure that the assets are managed and distributed according to your wishes. The appointed trustee can supervise the trust and distribute the assets responsibly, ensuring that the benefits are not squandered.

Shield Assets from Creditors and Legal Action

An ILIT provides asset protection by shielding your insurance benefits from creditors, divorce, and legal action. The assets held in an ILIT are not considered owned by the beneficiaries, making it difficult for courts and creditors to access them. This adds an extra layer of protection for your beneficiaries and ensures that your assets are used according to your wishes.

Avoid Probate

Creating an ILIT can help keep the policy's benefits out of any potential probate process. Probate occurs when there is a legal dispute over your assets and how they are bequeathed. An ILIT provides asset protection benefits that keep the covered property out of any legal challenges, ensuring that your wishes are carried out.

Avoiding gift taxes

An Irrevocable Life Insurance Trust (ILIT) is a powerful tool for estate planning and can be used to avoid gift taxes. Here are some key considerations for avoiding gift taxes when funding an ILIT:

Understanding Gift Taxes

First, it is important to understand what gift taxes are. In 2025, you can give up to $19,000 per year to an individual without needing to report it to the Internal Revenue Service (IRS). This amount was $18,000 in 2024. For married couples filing jointly, the amount doubles to $38,000 in 2025. If you exceed these limits, you must report the gift to the IRS using Form 709. However, you generally don't need to pay taxes on these gifts unless you exceed the lifetime gift exemption amount, which is $13.99 million in 2025 (up from $13.16 million in 2024).

Using Annual Gift Tax Exclusion

To avoid gift taxes when funding an ILIT, you can utilise the annual gift tax exclusion. This means that gifts or contributions to the ILIT can be structured as gifts to the beneficiaries. By using a "Crummey letter," the trustee notifies the beneficiaries of their right to withdraw a portion of the contributions for a 30-day period. After this period, the trustee can use the remaining contributions to pay the insurance policy premium. This qualifies the transfer for the annual gift tax exclusion, avoiding gift tax consequences.

Timing and Policy Selection

When transferring an existing policy to an ILIT, there is a three-year waiting period before the death benefits are excluded from your estate. Therefore, it is important to plan ahead and set up the ILIT at least three years before you anticipate needing the benefits. Additionally, consider the type of life insurance policy you want to place in the trust. While a term life insurance policy can be used, a permanent policy, such as whole life or universal life insurance, is more common due to their guaranteed death benefit.

Seeking Professional Guidance

Creating and funding an ILIT can be complex, and it is important to seek professional guidance. Consult with a qualified estate planning attorney, financial professional, or tax expert to ensure you understand the tax implications and make the best decisions for your specific situation. They can help you navigate the strict drafting and procedural guidelines to ensure your ILIT complies with Internal Revenue Service (IRS) requirements.

Tax considerations

Irrevocable Life Insurance Trusts (ILITs) are a powerful tool for minimising estate taxes. When a life insurance policy is owned by an individual, the death benefit is included in their gross estate and is subject to state and federal estate taxation. However, when the same policy is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and are therefore not taxed. This can result in significant tax savings for large estates.

ILITs also help to avoid gift taxes. Contributions made by the grantor to the trust are considered gifts to the beneficiaries. To avoid gift taxes, the trustee must notify the beneficiaries of their right to withdraw their share of the contributions for a 30-day period using a Crummey letter. After 30 days, the trustee can use the contributions to pay the insurance policy premium, and the transfer qualifies for the annual gift tax exclusion.

In addition, ILITs can protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid. The trustee can carefully manage distributions to ensure they do not interfere with the beneficiary's eligibility for government benefits.

While ILITs offer favourable tax treatment, it is important to note that once a death benefit has been paid, if the proceeds remain in the trust, any investment income earned and not distributed to the beneficiaries may be subject to taxation.

The creation and funding of an ILIT must also be carefully timed due to the IRS's three-year lookback period. If a life insurance policy is transferred to an ILIT within three years of the grantor's death, the insurance proceeds will be included in their taxable estate. To avoid this, the trust itself can apply for and acquire the policy directly.

Frequently asked questions