How Does an Irrevocable Life Insurance Trust Work?
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An irrevocable life insurance trust (ILIT) gives you additional control over your insurance policy and how the death benefit will be issued to your beneficiaries once you pass away. Since a life insurance policy is considered an investment and an asset, it will be included within your estate after your death. For this reason, proceeds — the death benefit — can be subject to an estate tax if your combined assets exceed the exemption limit set by the federal government.
Understanding life insurance trusts
Irrevocable life insurance trusts are estate planning tools that are often used to allow for further flexibility to transfer wealth from a parent to their dependents. Furthermore, they can provide more control over your life insurance policy and how the money is paid from it once you pass away.
An insurance trust has three components you must be aware of:
- Grantor: The person who is creating the trust (that's you)
- Trustee: The person who is managing the trust for you
- Trust beneficiaries: Named individuals who will receive the assets in the trust after you die
For example, you could purchase a life insurance policy for yourself, making you the insured. You can then take this policy and transfer it into an irrevocable life insurance trust in which you would be the grantor and you could name your dependents as trustees.
If the grantor were to pass away, the life insurance death benefit is paid out into the trust, at which point the trustee would collect the funds and use them however the grantor requested. Usually, the grantor would set up the trust so that they can provide detailed instructions on how the funds would be used. One such way would be for the grantor to name their children as the trust beneficiaries, but there are many ways that these financial vessels can be utilized.
How to choose a trustee
The most important individual in the trust is the ILIT trustee.
This is because the trustee is responsible for the distribution of proceeds and management of the trust.
Some people will name their spouse or adult child as the trustee, but sometimes your loved ones do not have enough expertise to understand the role. In this case, you could name a corporate trustee such as the bank to oversee the trust properly.
Advantages of irrevocable life insurance trusts
Life insurance trusts have several advantages for estate planners and individuals, with the main one being minimizing and paying for estate taxes.
Minimizing estate taxes
If you own a life insurance policy and you pass away, the death benefit from the plan is considered an asset and thus is included within your aggregate estate. But, if you were to place the life insurance within the ILIT, then the death benefit proceeds would not be included in your estate and would not become taxable.
In some cases, by not including your life insurance, you may be able to reduce your entire estate net worth below the federal exemption level and avoid the taxes altogether.
Paying for estate taxes with death benefit proceeds
If the trust is set up correctly, death benefit proceeds could be used to help pay for estate taxes on other assets of the deceased.
For example, say you have accumulated an estate of $15 million that consists of property, retirement accounts and stocks. At that level, you would need to pay estate tax. Your trustee could use the death benefit proceeds from your life insurance policy to bear the burden of that tax, thus allowing your beneficiaries to receive the full value of the other assets outside of the trust.
How does an estate tax work?
Your estate is all the money and property that you own. After you die, your estate will have to pay federal estate taxes if the total value is more than the exempt amount allowed by law. For 2020, the estate tax exemption is $11.58 million. This means that an individual can leave $11.58 million to any heirs and be completely exempt from paying estate taxes. Furthermore, if it is a married couple, the exemption would double to $23.16 million.
So, for example, say you had a life insurance policy worth $8 million and other assets such as property, cash and investments worth $4.58 million at your death. At this point, your total estate would be worth $12.58 million and thus would exceed the exemption amount specified by the federal government. Therefore, the value over $11.58 million — or $1 million — would be subject to the estate tax. But with an ILIT, you would be able to shield your assets from this.
Which states have an estate tax?
If you are not subject to the federal estate tax, you may still have to incur the state-level estate tax depending on where you live. These estate taxes have exemption levels that are much lower when compared to the federal level. Below are the states that levy a tax on your estate:
State | Asset exemption amount |
|---|---|
| Connecticut | $5.1 million |
| District of Columbia | $5.682 million |
| Hawaii | $5.49 million |
| Illinois | $4 million |
| Maine | $5.7 million |
| Maryland | $5 million |
| Massachusetts | $1 million |
| Minnesota | $3 million |
| New York | $5.85 million |
| Oregon | $1 million |
| Rhode Island | $1.562 million |
| Vermont | $4.25 million |
Other irrevocable life insurance trust benefits
Life insurance trusts have many benefits outside of being used for estate tax purposes. These include but are not limited to:
- Maximize control over proceeds: A trust will allow you, the insured, to give detailed instructions on how the death benefit should be used. Typically, death benefit proceeds are given to the beneficiary either in a lump sum or over a specified payment schedule. With a trust, you can give added instructions, such as holding back funds if the trust beneficiaries are too young or placing funds into different investment accounts to be used in the future.
- Provide income to spouse: If the life insurance policy is put into a trust, the death benefit can provide income to your spouse without increasing your spouse's estate.
- Prevent outside control of the life insurance: In typical life insurance scenarios, if the beneficiary becomes incapacitated, becomes ill or dies, the insurance proceeds would then get transferred directly to the estate. But if the life insurance was placed within the trust, this scenario would not happen.
How to set up a trust
Setting up a trust properly can be a confusing process, and we recommend reaching out to a financial planning professional such as a certified public accountant (CPA), bank or trust planner. If you do not set up a trust properly, then the many benefits of these financial vessels might not be realized.