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How Does an Irrevocable Life Insurance Trust Work?

An irrevocable life insurance trust (ILIT) allows you to have more control over your insurance policy and how the death benefit is distributed to your beneficiaries after you die. Because a life insurance policy is considered an asset and an investment, it will be included in your estate upon your death. As a result, if your total assets exceed the federal government's exemption limit, the proceeds — the death benefit — may be subject to an estate tax.

Understanding life insurance trusts

Irrevocable life insurance trusts are estate planning tools that are frequently used to provide additional flexibility in transferring wealth from a parent to their dependents. Furthermore, they can give you more control over your life insurance policy and how the money is distributed from it after you die.

You should be aware of three components of an insurance trust:

• Grantor: The person who creates the trust (you).
• Trustee: The person in charge of managing your trust.
• Trust beneficiaries: Individuals named who will receive the trust assets after you die.

You could, for example, buy a life insurance policy for yourself, making you the insured. You can then transfer this policy into an irrevocable life insurance trust in which you are the grantor and your dependents are trustees.

If the grantor dies, the life insurance death benefit is paid into the trust, at which point the trustee collects the funds and uses them as the grantor directed. Typically, the grantor would establish the trust in order to provide detailed instructions on how the funds would be used. One example would be for the grantor to name their children as trust beneficiaries, but there are numerous ways in which these financial vehicles can be used.

How to choose a trustee

The ILIT trustee is the most important person in the trust.

This is because the trustee is in charge of the trust's distribution and management.

Some people will name their spouse or adult child as trustee, but your loved ones may not have the necessary expertise. In this case, you could appoint a corporate trustee, such as a bank, to properly oversee the trust.

Advantages of irrevocable life insurance trusts

The main benefit of life insurance trusts for estate planners and individuals is that they reduce and pay estate taxes.

Minimizing estate taxes

If you have a life insurance policy and die, the death benefit is considered an asset and is thus included in your total estate. However, if you place the life insurance in an ILIT, the death benefit proceeds will not be included in your estate and will not be taxable.

In some cases, not including your life insurance may allow you to reduce your total estate net worth below the federal exemption level and avoid paying taxes entirely.

Paying for estate taxes with death benefit proceeds

If the trust is properly set up, the death benefit proceeds could be used to help pay estate taxes on the deceased's other assets.

Assume you have accumulated a $15 million estate consisting of real estate, retirement accounts, and stocks. You would have to pay estate tax at that level. Your trustee could use the death benefit proceeds from your life insurance policy to pay the tax, allowing your beneficiaries to receive the full value of the trust's other assets.

How does an estate tax work?

Your estate includes all of your money and property. If the total value of your estate exceeds the law's exempt amount, your estate will be required to pay federal estate taxes. The estate tax exemption for 2020 is $11.58 million. This means that an individual can leave $11.58 million to any heirs and avoid paying estate taxes entirely. Furthermore, if the couple is married, the exemption is doubled to $23.16 million.

Assume you died with a $8 million life insurance policy and $4.58 million in other assets such as property, cash, and investments. At this point, your total estate would be worth $12.58 million, exceeding the federal government's exemption amount. As a result, any value greater than $11.58 million — or $1 million — would be subject to the estate tax. However, with an ILIT, you can protect your assets from this.

Which states have an estate tax?

Even if you are not subject to the federal estate tax, you may be subject to the state estate tax depending on where you live. When compared to the federal level, these estate taxes have much lower exemption levels. The following states impose an estate tax:

Other irrevocable life insurance trust benefits

Aside from being used for estate tax purposes, life insurance trusts have numerous advantages. Among these are, but are not limited to:

• Increase your control over the proceeds: A trust allows you, the insured, to give specific instructions on how the death benefit should be used. Death benefit proceeds are typically paid to the beneficiary in a lump sum or over a specified payment schedule. You can give additional instructions with a trust, such as withholding funds if the trust beneficiaries are too young, or directing funds to different investment accounts to be used in the future.
• Provide income to spouse: If the life insurance policy is placed in a trust, the death benefit can provide income to your spouse while not increasing the value of your spouse's estate.
• Prevent outside control of the life insurance: Normally, if the beneficiary becomes incapacitated, becomes ill, or dies, the insurance proceeds are transferred directly to the estate. This scenario, however, would not occur if the life insurance was placed within the trust.

How to set up a trust

Setting up a trust correctly can be a difficult process, so we recommend consulting with a financial planning professional such as a certified public accountant (CPA), bank, or trust planner. If you do not properly set up a trust, the many benefits of these financial vehicles may not be realized.