An Irrevocable Life Insurance Trust (ILIT) is one of the most powerful and underused tools in estate planning. An ILIT can keep life insurance out of your taxable estate and can be set up to lock in your children’s inheritance and protect it from divorcing spouses and bad decisions.

Background

If you have a $1 million life insurance policy, your beneficiary will receive the $1 million death benefit when you die. There are three important facts you need to know about the death benefit:

1. It’s income tax-free.  Your beneficiary will not have to pay income tax on the life insurance death benefit.
   
   
2. It will be included in your estate for estate tax purposes.  However, since President Trump’s One Big Beautiful Bill permanently (until they change it and it’s no longer permanent) locked in the estate tax exemption at $15 million per person, increased annually for inflation ($30 million for married couples), most people don’t have to worry about the estate tax. 
   
   
3. Unless you plan ahead, your life insurance beneficiary will receive the death benefit outright. An outright distribution is straightforward and simple - a check from the insurance company written to your beneficiary that she will deposit in her checking account, but an outright distribution can be fraught with dangers, including:

• An immature beneficiary can blow the money on parties, Draftkings, and a G-Wagon.
  
  
• A married beneficiary can accidentally transmute separate property (inherited assets are separate property) into community property, and if there is a divorce, the soon-to-be ex-spouse can get half.
  
  
• An outright distribution is fair game to a creditor or a plaintiff in a lawsuit. 
  
  
• An outright distribution is fair game to a creditor or a plaintiff in a lawsuit.

What is an ILIT?

An ILIT is an irrevocable trust that owns life insurance. A typical ILIT looks like this:

Grantor: You or you and your spouse create the ILIT.

Trustee: Someone other than the grantor is the trustee. It’s often an adult child or other family member.

Beneficiary: In most cases, you will name your children as beneficiaries.

Once the ILIT is set up, the ILIT trustee applies for a life insurance policy on the grantor's life, usually a permanent policy, though in some circumstances, a term policy is used.

Note: Have the ILIT trustee apply for a new policy rather than transferring an existing one, as transferred policies may be pulled back into your estate for three years under IRC §2035.

When the premium payment is due, the grantor writes a check to the ILIT trustee, who deposits it into an ILIT bank account set up with a trust EIN (tax identification number). The trustee then pays the premium out of the ILIT bank account.

To keep the policy death benefit out of the grantor’s estate and to leverage the grantor’s gift tax exemption, the trustee must send notices (called Crummey notices - named after a court case about a guy named Crummey) to the ILIT beneficiaries.

The nutshell version: the grantor makes a cash gift to the ILIT trustee, who then purchases the life insurance policy with that cash. The ILIT owns the life insurance policy and is the policy beneficiary. When the grantor dies, the insurance company pays the death benefit to the ILIT, and the ILIT trustee distributes the proceeds to the ILIT beneficiaries in accordance with the ILIT trust terms.

Why Would You Use an ILIT?

Here are some situations where an ILIT would be very beneficial:

Avoid Estate Tax

If your life insurance policy is owned in an ILIT, the death benefit will not be included in your taxable estate. Each time you write a check to the ILIT trustee, you are making a gift to the ILIT beneficiaries. The trustee uses the gifted cash to buy the life insurance policy. As a result, you don’t own the policy; the ILIT owns the policy. Consequently, when you die, the ILIT receives the death benefit outside your estate. The $1 million death benefit used in the example above will not be included in your estate and, therefore, will not be subject to estate tax.

As I explained above, for most people, it won’t matter whether the death benefit is included in their estate, since the current estate tax exemption is $15 million. But for those with an estate close to or exceeding $15 million, or $30 million for a married couple, adding a life insurance death benefit to their estate may put them over the threshold. 

If you had a $3 million home, $12 million in investments, and a $1 million life insurance policy, your total estate would be $16,000,000, which is $1 million more than the $15 million exemption. The estate tax is 40%. Your estate tax would be:

Estate value $16,000,000

Exemption -$15,000,000

Taxable Estate $1,000,000

Estate Tax $1,000,000 (40%) = $400,000

However, if your life insurance policy was owned by an ILIT, your estate value would be $15,000,000, and, therefore, no estate tax.

Estate value $15,000,000 ($1m policy is outside your estate)

Exemption -$15,000,000

Taxable Estate $0

Estate Tax $0

Create a Protected Asset for Your Children

Life insurance is a great tool for estate planning. If you need to level up your children’s inheritance, life insurance can create an instant asset when you die. And, an ILIT can significantly protect the death benefits for your children. Let’s explore a few examples.

Divorce Protection

If you named your daughter as the beneficiary of your life insurance policy, then upon your death, she would receive a check from the insurance company. If she is married, she might deposit the check into her checking account, which happens to be a joint account with her husband. By doing this, she unwittingly transmuted separate property (the insurance death benefit) to community property. If she and her husband divorce, he can claim half of the joint account. Not a good result.

This would not happen if you used an ILIT to own the life insurance policy. The insurance company would write the death benefit check to the trustee of the ILIT, and the trustee would use it to fund an asset protection trust for your daughter. The asset protection trust would be a subtrust of the ILIT that is created upon your death. Your daughter would be the beneficiary, and, if she is old enough (most of our clients choose age 25-30 as the age at which a beneficiary can be trustee), she can serve as trustee of her trust. As trustee, she would have full control of how to invest and spend the trust funds. But, and this is a big but: so long as the funds remain in trust, regardless of how they are invested, they are protected from a divorcing spouse.

If you used an ILIT to own your life insurance policy, your daughter’s divorcing spouse could not get a dime of her life insurance inheritance. 

Management for Young or Immature Beneficiaries

Let’s say you have young children, or an adult child who simply isn't good with money. With an ILIT, you can name your brother or sister or friend to serve as trustee to manage your child’s asset protection trust until they are mature enough to take over. Many people are not comfortable with their 18-year-old managing a pile of cash. Better to have a responsible family member or friend manage his funds. After all, you didn’t work to pay the life insurance premiums for it to be wasted by a spendthrift child. You want the trust assets to be there to help them get on with a productive life, not to fuel a trust-fund baby lifestyle.

Secure an Inheritance for Your Children After a Second Marriage

What if you are in a second or third marriage and you want to provide an inheritance for your children - safe from your new spouse and your step-kids? You’ve come to the realization that you will have to leave everything to your current spouse. But what about your kids from your first marriage? They are your blood, and they’ve been with you since they were born. It may be risky to hope your second spouse won’t change your estate plan after you die and leave everything to her kids. Hope is not a good strategy.

With a little effort and planning, you can set up an ILIT and pay the premiums with separate property funds, so that if your new spouse gets everything else, at least your children will get the life insurance from the ILIT.

Equalize Inheritance

If you have certain assets that you intend to leave to a specific child, such as a home or business, do you have enough other assets to leave to your other children? This is often the case with business owners when only one child works in the business, or when a child lives in your home, maybe even taking care of you, and you want that child to be able to keep the home. Life insurance in an ILIT can be a great equalizer.

Wealth Replacement with Charitable Giving

If you are charitably inclined and intend to leave gifts to your favorite charity and an inheritance to your children, you can pair an ILIT with a charitable remainder trust (CRT) to leverage your charitable deduction and tax savings. With the savings in capital gain from selling appreciated assets in the CRT, you can fund a life insurance policy in an ILIT for the benefit of your children to more than replace the value of the asset you gifted to the CRT.

Do You Need an ILIT?

ILITs aren’t for everyone, but if you are in one of the scenarios described above, an ILIT can be an important part of your estate plan.

If you are considering setting up an ILIT, we recommend you work with an experienced life insurance agent and an experienced estate planning attorney. 

For the ILIT to work correctly, you will need your insurance agent and estate planning attorney to work together. An ILIT is an advanced estate planning tool that must be administered correctly. But if it is done correctly, it will be a valuable part of your estate plan.

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Virtual Estate Planning

El Dorado Hills

Roseville

San Diego

San Luis Obispo