Navigating Estate and Trust Planning with ILITs

Life insurance provides reassurance to individuals concerned about securing their family legacy. However, if your estate is large enough that estate taxes will be a concern, it’s important to not directly own the policy at death. The policy’s proceeds will be included in your taxable estate and may be subject to estate tax. To avoid this result, a common estate and trust planning strategy is to draft an irrevocable life insurance trust (ILIT) to hold the policy. Here, Emily Blackburn, J.D., CPA, Partner, explores the benefits of including an ILIT in your estate plan.

Avoiding Incidents of Ownership

Generally, if you don’t own it directly, the proceeds of a life insurance policy aren’t included in your taxable estate. However, “incidents of ownership,” beyond mere possession, lead to inclusion of life insurance proceeds in the taxable estate. These incidents include rights such as altering beneficiaries or borrowing against the cash value.

Avoiding incidents of ownership is imperative because the top estate tax rate is currently 40%. Fortunately, leveraging the gift and estate tax exemption allows sheltering up to $13.61 million (for 2024) of assets from federal gift and estate tax. However, beyond 2025, the exemption is scheduled to revert to $5 million (indexed for inflation) without congressional action.

Further estate or inheritance tax concerns may arise at the state level as well. For example, Minnesota estates are taxable at just $3 million. So, the estate tax treatment of life insurance policies remains an important consideration in estate planning, especially for wealthier individuals.

Role and Function of an ILIT

Utilizing an ILIT can be an effective method for avoiding these estate tax complications. This can be accomplished by setting up a trust that then purchases life insurance coverage, or by transferring an existing policy to the trust as the owner of the life insurance policy.

The trust must be “irrevocable,” meaning the relinquishment of any control over the ILIT, including beneficiary revisions or trust revocation. Acting as the trustee of the ILIT constitutes an incident of ownership that will invalidate the trust.

The owner and primary beneficiary of the life insurance policy will be the ILIT. On your death, the proceeds are moved into the ILIT and held for distribution to the trust’s beneficiaries, such as your spouse, children, grandchildren or other family members. However, designating a surviving spouse as the sole beneficiary might merely delay the estate tax liability until their passing. Effective estate and trust planning reduces the risk for missteps like these.

Avoiding ILIT Pitfalls

There are a few red flags to be aware of when transferring an insurance policy to an ILIT. Notably, if you transfer an existing policy to the ILIT and pass away within three years of the transfer, the proceeds will still be included in your taxable estate. One way to mitigate this risk is for the ILIT to purchase the policy on your life and gradually fund the trust to cover premiums. Estate and trust planning leans heavily on seasoned advisors who can assist you with navigating these tricky rules and regulations.

Make sure to consider that the transfer of an existing policy to an ILIT is considered a taxable gift. Further, subsequent transfers to the trust would also be treated as gifts. The gifts can be sheltered from tax by your available gift and estate tax exemption.

Additionally, if the purpose of the life insurance is to provide liquidity for estate taxes, be sure that the ILIT is drafted in such a manner as to allow for your estate to pay for these taxes by doing either of the following:

1.  Borrowing from the ILIT

2.  Selling assets from the estate to the ILIT for cash.

If the ILIT pays estate taxes outright from the trust, it could cause the value of the ILIT to be included in your taxable estate, which defeats the purpose of ILIT planning.

One of the largest tradeoffs stems from the irrevocable nature of the ILIT; your life insurance policy is now an asset of the ILIT and its future beneficiaries. And while the previous owner of the life insurance policy might not benefit, ILITs can create a reliable source of future income for beneficiaries like minor children or other family members that lack financial savvy. But the trust may also accrue associated costs, like filing gift tax returns or legal fees, which need to be addressed during the estate and trust planning stages.

Helping You Get There…

Life insurance serves as a powerful estate planning tool. It creates an instant source of wealth and liquidity to meet your family’s financial needs posthumously. To shield proceeds from estate tax implications, consider establishing an ILIT to manage your policy and help secure peace of mind for the future. Contact a member of the estate and trust planning team at Boulay to determine if an ILIT is right for you and your future.