Insurance Trust (ILIT): Overview, Benefits, FAQ

What Is an Insurance Trust (ILIT)?

An insurance trust is an irrevocable trust set up with a life insurance policy as the asset, allowing the grantor of the policy to exempt assets away from their taxable estate.

Once the life insurance policy is placed in the trust, the insured person no longer owns the policy, which will be managed by the trustee on behalf of the policy beneficiaries when the insured person dies.

Key Takeaways

Irrevocable life insurance trusts, or ILITs, are established with the grantor as the insured and the trust as the owner of the life insurance policy.
An insurance trust can offer some control over how your assets from insurance policies are used after your death.
An insurance trust can be used as part of a larger estate plan for your family.
For wealthy individuals, an insurance trust can protect against beneficiaries having to pay estate tax—although generally, beneficiaries pay no estate tax.
Because it is irrevocable, ILITs should be well-thought before creating them.

How an Insurance Trust (ILIT) Works

An irrevocable life insurance trust (ILIT) is a trust within which a life insurance policy is placed. Because it is irrevocable, it cannot be rescinded, amended, or modified after the fact. This means that once the grantor establishes the life insurance policy in the ILIT, they cannot change the terms of the policy or reclaim it.

As an alternative to naming an individual beneficiary to receive the death benefit of a life insurance policy when the insured passes away, ILITs provide several legal and financial advantages to one's heirs, such as more favorable tax treatment, asset protection, and assurances that the money received from the death benefit can only be used in a manner in-line with the deceased's wishes.

ILITs are also used to minimize the estate tax due for wealthier individuals. This is done by making the trust the owner of the policy and the grantor the insured. To avoid the incidence of ownership, the trust grantor can thus have the trust itself apply for the insurance policy and be the owner from inception.

For the life insurance policy to be excluded from one's personal estate, there must have been no incidence of ownership within the three years prior to the insured's death, meaning a policy must be transferred at least three years prior to their death. To avoid this, the trust can apply as a legal entity for the policy directly.

Steps to Take to Establish an ILIT

Steps that are ideal when establishing an ILIT:

ILIT is executed prior to policy application and any premium payment
Grantor transfer funds or gifts to ILIT for premium payments
ILIT trustee notifies beneficiaries of Crummey withdrawal rights each time gifts are transferred to the ILIT.
ILIT trustee applies for policy on grantor's life as owner and beneficiary of the insurance policy

In the U.S., proper ownership of life insurance is important if the insurance proceeds are to escape federal estate taxation. If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.) To avoid estate taxation, some insureds name a child, spouse, or another beneficiary as the owner of the policy.

Beneficiaries do not have the power to make changes to an ILIT but they may have current withdrawal rights or powers under the Crummey powers.

Benefits of an ILIT

If you are the insured and also own the life insurance personally, the death benefit will be considered part of the value of your overall estate when you pass away. This could potentially expose your heirs to estate tax upon your death. (For 2022, the estate tax value threshold is $12.06 million, increasing to 12.92 million in 2023.) When put into an ILIT, however, the trust becomes the owner of the policy. The proceeds from the death benefit, therefore, are no longer included in the insured's gross estate, and wouldn't contribute toward the value of the estate, thus minimizing potential estate tax exposure.

ILITs can also be structured to avoid gift taxes made to one's beneficiaries. (As of 2022, the gift tax threshold is $16,000 per year per recipient, increasing to $17,000 in 2023.) In this case, premiums paid to the policy inside of the ILIT can be construed as a gift, but the gift tax can be avoided if a Crummey Letter is drafted stipulating that the gift is being made to the trust.

Another benefit of an ILIT is that the trust can establish rules by which beneficiaries must adhere when the death benefit is paid. The trust document can stipulate only a certain amount of money per year be withdrawn, for example, or that the proceeds can only be used for certain things like a college education, until the beneficiary reaches, say, 25 years of age. Such guidelines can also become useful in the case of second (or third) marriages to ensure that only the insured's children (or other stated beneficiaries) have a legal claim to the funds.

Life insurance held in an ILIT, like other assets held in irrevocable trusts, are also shielded from creditors and the IRS.

Special Considerations

There are, however, certain drawbacks to an ILIT arrangement. For instance, creating an insurance trust may not always be inconsistent with the wishes of the insured or the best interests of their beneficiaries. For those with relatively small estates that would not normally be subject to estate tax in the first place, creating an ILIT can be expensive and time-consuming.

Furthermore, while ILIT proceeds are not taxed as part of the insured's estate, they could be taxed as part of the beneficiaries' estates, consequently leaving a potentially bigger tax burden on one's descendants.

Another downside is that once the ILIT has been established, it cannot be modified or recalled at a later date. This means that a change of heart or change of circumstances would not allow the grantor to do anything about it.

The process involved in properly establishing and funding an ILIT can be complex, with strict legal and procedural guidelines that must be met. It is highly recommended to consult with a seasoned trust lawyer or a tax specialist along with an insurance agent to coordinate an ILIT.

What Is a Variable Insurance Trust?

A variable insurance trust (VIT) is an investment product used to fund pensions, annuities, and insurance benefits offered by organizations, such as corporations, to their employees. The value of the fund responsible for paying these retirement benefits would be subject to changes in the market value of the associated investments. VITs are not offered to individuals.

How Can You Terminate an Irrevocable Life Insurance Trust?

To unwind, or terminate an ILIT, strict criteria must be met.

One method is to substitute the value of the life insurance policy inside the trust with an equivalent amount of cash. The life insurance policy then reverts back to the individual owner and the ILIT becomes a grantor trust instead.
A second method is to simply stop paying premiums to the policy, allowing it to lapse. This is usually only cost-effective if the ILIT holds a term life policy that does not have any accumulated cash value.
If the insured is older, it is possible to sell the policy inside the ILIT via a life settlement arrangement. In this case, the life settlement buyer becomes the new policy owner and beneficiary. In return, the trust receives a lump-sum cash payment. Note that this may only be an option if the insured is 60 years of age or older.
Seeking a legal injunction to terminate the ILIT is a more difficult option, but can be achieved if it can be proven that the ILIT was created under false pretenses. In other cases, the trust may be written giving permission to the trustee to terminate the trust under particular circumstances. This would often also require consent by both the grantor and the beneficiaries.

Is Life Insurance Taxable If Paid to a Trust?

The proceeds from a life insurance death benefit are always delivered income-tax-free to the beneficiaries. This would also be true of a trust. However, life insurance proceeds may increase the value of an estate above the threshold for the estate tax. If held in trust, this would not occur; however, it could increase the value of the beneficiaries' estates.