Why an irrevocable life insurance trust is a smart financial move 

There are useful tools available to advisors and investors when it comes to estate planning. One of the tools that stands out is the irrevocable life insurance trust (ILIT). This is a form of irrevocable trust where the asset involved is the death benefit of the grantor’s life insurance policy.  

In an ILIT, the grantor or creator of the trust cannot change the terms or beneficiaries of the trust, just like any irrevocable trust. However, grantors may place one or more life insurance policies within the ILIT.  

So, what is an irrevocable life insurance trust? How does it work? What are the benefits of this type of trust? Find the answers to these and more in this article.  

What is an irrevocable life insurance trust? 

The irrevocable life insurance trust or ILIT (pronounced “eye-lit”) is one of the estate planning tools that can be used to reduce estate taxes. Using this type of trust can make sure that the grantor passes on a larger, less tax-burdened inheritance to their beneficiaries.  

An irrevocable life insurance trust is unique in that it mainly manages life insurance policies and allocates the life insurance death benefits once the grantor dies. Once established, ILITs are irrevocable, which means they typically cannot be altered or terminated. 

Terms to remember for irrevocable life insurance trusts 

When it comes to an irrevocable life insurance trust, here are the most important terms to keep in mind: 

1. Grantor 

The grantor is the person who initiates and finances the trust. Also, they are the only person who can choose a trustee to manage the trust. 

2. Trustee 

The individual or entity appointed by the grantor to manage the trust. Trustees can be: 

• a family member 
• grantor’s trusted friend 
• grantor’s trusted advisor, like a financial planner, lawyer, or accountant 
• a bank 
• trust company 

It’s the trustee’s duty to: 

• collect the life insurance premiums 
• collect the death benefit when the grantor dies 
• oversee payouts to the beneficiaries 

3. Beneficiary or beneficiaries 

These are the people that the grantor chooses to receive the trust’s benefits. Grantors can choose one or more beneficiaries. The beneficiaries of an ILIT can be the grantor’s spouse, children, or grandchildren.  

How does the irrevocable life insurance trust work? 

The ILIT works by owning and controlling a term insurance or permanent life insurance policy while the insured is still alive. An ILIT can own and control one or more policies.  

ILITs also work by managing and distributing the death benefits to the named beneficiaries after the grantor has died. The death benefits go directly into the ILIT, which are then paid out to the beneficiaries according to the insured/grantor’s wishes.  

How irrevocable life insurance trusts compare with other types of trusts: 

Feature	Revocable trust	Irrevocable trust	Irrevocable life insurance trust
Needs a lawyer to draft?	No	Yes	Yes
Fiduciary duty?	No	Yes	Yes
Who manages the trust?	Grantor	Assigned Trustee	Assigned Trustee
Avoids probate?	Yes	Yes	Yes
Can it be amended?	Yes	No	No

While both irrevocable trusts are typically unchangeable once finalized, they can be revoked or amended in certain circumstances with a court order. 

What are the pros and cons of an irrevocable life insurance trust?  

Is an irrevocable life insurance trust a viable estate planning tool for an individual investor? The only way to know is to weigh its benefits and drawbacks:

The pros of an irrevocable life insurance trust 

It can be used to pay for estate taxes 

If the grantor has a large estate with a variety of assets, the ILIT and the insurance policy or policies contained within it can be used to pay for the estate tax. Since the assets within the ILIT are non-taxable, the death benefit itself can pay for the taxes on other inherited assets.  

It shrinks estate taxes 

Typically, the death benefit of a life insurance policy gets its share of estate taxes after the grantor dies. If the insurance policy is placed within an irrevocable life insurance trust, the death benefit is exempt from estate taxes since the trust owns the policy. Using the irrevocable life insurance trust, along with other irrevocable trusts for other assets, can reduce the grantor’s estate taxes even more.  

It protects assets  

Only the beneficiaries have access to the income from the life insurance policies or its death benefit. That means creditors, ex-spouses or plaintiffs cannot attach the trust’s assets to satisfy court rulings, whether against the grantor or the beneficiaries. 

It helps avoid gift taxes 

Typically, a direct gift from a grantor to their beneficiaries incurs a gift tax. But in the irrevocable life insurance trust, the trustee takes money the grantor contributes to the trust and uses it to pay the premiums of the life insurance policy.  

These transfers to the trustee are included in the grantor’s annual gift tax exclusion. For this to work, however, the grantor must also issue a Crummey letter or notice to do this process legally.  

It ensures eligibility for government benefits 

If a beneficiary receives disability benefits, Medicaid, or other government benefits, the trustee can limit the amount the beneficiary gets. That way, the beneficiary can still receve distributions from the trust without becoming ineligible for their government benefits.  

It can carry out the grantor’s wishes even after they’re gone 

In an irrevocable life insurance trust, the trustee is empowered to distribute the assets according to the grantor’s wishes. The grantor specifies what or how much goes to whom, and when. For example, if the grantor has minor children as beneficiaries, they can stipulate that they only get a portion of the trust assets or the entire amount when they enter college or start a family.  

It can be used as a legacy-planning tool 

Although the generation-skipping trust can be used as a wealth-preserving, legacy-planning tool, this can be further enhanced with an irrevocable life insurance trust. Since the ILIT excludes the death benefit from the grantor’s estate, their children, grandchildren, and great-grandchildren can get this free of any estate or GST tax.  

It is not taxed 

Irrevocable trusts are still taxed, are required to have a separate tax number, and have an aggressive tax schedule. Not so with an ILIT; the accumulated cash and the death benefit itself are exempt from any tax.

The cons of an irrevocable life insurance trust   

The trustee must do their due diligence 

A trustee’s job is not simply to act in the best interest of the beneficiaries and execute the terms of the trust. They must monitor the earnings of the trust and make sure they are distributed to the right beneficiaries. Any proceeds from the insurance policy or investment income earned should be given to the beneficiaries. If these remain in the trust, they can be taxed.  

No changes can be made to the trust 

As with any irrevocable trust, once the irrevocable life insurance trust is finalized, it cannot be changed or revoked. Any assets placed in the trust no longer belong to the grantor and they may not be able to access the assets if they need them. The only way the trust can be revoked is by court order.  

Potentially high cost 

Establishing any sort of trust costs money. An irrevocable life insurance trust can be expensive, especially if the grantor decides to hire an expert lawyer or trust company to draft it. The trust can also be costly if the grantor decides to place more than one policy in it. Lastly, the grantor may have to pay gift taxes in the year they fund the trust and in later years. 

Here’s a video from an estate planning attorney. In it, he discusses the pros and cons of an irrevocable life insurance trust and outlines the steps involved in creating one:  

Find out more about the best uses of irrevocable trusts in one of our guides.  

How do you fund an irrevocable life insurance trust? 

There are two ways to fund an irrevocable life insurance trust. Grantors can transfer an existing life insurance policy or create a new one. For each option, here are the guidelines:  

1. transferring an existing insurance policy – The owner of the policy (usually the insured) must change the policy’s owner to the trust. The grantor may also have to change the policy’s beneficiary to the trust depending on how you want the death benefit to be distributed. 

2. funding the trust with a new insurance policy – In this case, the grantor can name the trust as beneficiary and tailor-fit the new policy to suit their purposes. By getting a new insurance policy, the three-year waiting period for the irrevocable life insurance trust is avoided. 

What is the 3-year rule for irrevocable life insurance trusts? 

If the grantor transfers their life insurance policy to an irrevocable life insurance trust within 3 years before their death, then the insurance proceeds are considered part of their taxable estate. This is standard practice for the IRS, which hopes to prevent “deathbed gifts” that avoid taxation.  

Is there a workaround for this 3-year rule? 

Yes. Grantors can avoid this 3-year lookback period by having the irrevocable life insurance trust make the application for the life insurance policy and directly acquire it. In this manner, the insured grantor does not make the trust subject to the 3-year lookback rule. 

Getting a new insurance policy means having to pay for a new application, getting another physical exam, etc. 

Another option is to simply transfer the existing policy. Doing this makes the tax benefits effective 3 years after the existing policy is transferred into the trust.  

Irrevocable life insurance trusts for estate planning 

Irrevocable life insurance trusts are a tax-efficient estate planning tool that can transfer wealth to beneficiaries outside of the grantor’s taxable estate. They’re also effective in keeping legacy assets out of reach of potential creditors of both the grantor and their beneficiaries. 

For beneficiaries with special needs, an irrevocable life insurance trust can help earmark assets for their continued care without affecting their eligibility for government benefits.  

Advisors should be aware of the lifetime gift and estate tax exemption limits, which are well above what most Americans might accumulate in their lifetimes. As of now, it’s still at $12.92 million for individuals and $25.84 million for married couples, so setting up an ILIT may seem moot.   

But on the other hand, the ILIT may yet prove useful if US Congress allows the deadline of Tax Cuts and Jobs Act of 2017 to lapse in December 2025. If that happens, limits will revert to $5 million per person. 

Investors should not put off their estate planning in this regard, even though many high-net-worth individuals are enjoying longer lifespans. With this sort of uncertainty, more investors are advised to consider the potential benefits of making the irrevocable life insurance trust part of their estate and legacy planning strategy. 

For more on irrevocable trusts and other estate planning tools, read and bookmark our retirement page. You’ll find tips and strategies to help you support clients with planning for the future.