by: Michael Mueller, Senior Financial Planner
Some numbers in this article have been updated to reflect annual indexing, effective January 1, 2024.
Wealthy Individuals often employ a wide range of estate planning strategies to minimize their estate’s potential tax burden. Among the most common is the Irrevocable Life Insurance Trust (ILIT), a trust that is the owner and beneficiary of a life insurance policy covering an individual or couple.
There are a variety of reasons to employ an ILIT, from minimizing overall estate and gift taxes to providing beneficiaries with sufficient liquidity to meet any estate tax obligations. Understanding exactly how an ILIT should be structured and managed is key to employing this strategy successfully, and there are various considerations that individuals should bear in mind before establishing an ILIT.
In this overview, we explain how an Irrevocable Life Insurance Trust works, walking through a hypothetical example to demonstrate the potential tax benefits for wealthy individuals. We will also outline how to establish an ILIT and explore several nuances that individuals should consider before starting the process of establishing this trust.
What is an Irrevocable Life Insurance Trust?
Irrevocable Life Insurance Trusts, typically referred to as ILITs, are a relatively simple way for wealthy individuals and couples to minimize potential estate taxes their assets will be subjected to upon their death.
ILITs are typically used by ultra-high net worth individuals and couples whose assets exceed the lifetime exemption. Today, the lifetime exemption for an individual is $13.61 million, doubled for married couples. However, in 2026, this lifetime exemption is set to be reduced to a much lower level, potentially bringing the ILIT’s strategy back in demand.
An ILIT is the owner and beneficiary of a life insurance policy on an individual or both spouses. Each year, an amount equivalent to the premium payments on the policy is gifted to the ILIT by the grantors, and the ILIT then makes these payments to the insurance company. These gifts are irrevocable and count toward the insured’s lifetime exemption if they exceed the annual gift tax exclusion – currently $18,000 per individual, double for married couples.
An ILIT can own an individual policy or a second-to-die life insurance policy that only pays out on the passing of the second spouse. ILITs most often own permanent life insurance policies, but can also be structured to own term insurance policies. When the insured party or parties pass, the payout from the life insurance policy is paid to the ILIT, which distributes these funds according to the terms of the trust. Crucially, these funds are not considered part of an individual’s estate.
Individuals who own a life insurance policy in their name will have the death benefit included in their estate. An ILIT effectively transfers these benefits out of an individual’s estate.
A Worked Example of the Estate Tax Savings Offered by an ILIT
To understand the estate tax benefits offered by an ILIT, it’s helpful to consider the following example that demonstrates the potential savings wealthy individuals and couples can realize.
In this example, a couple has an estate valued at $50,000,000. Both spouses have a lifetime exemption of $13,610,000, for a joint exemption of $27,220,000.
This leaves the following estate tax exposure:
Estate Value: $50,000,000
Lifetime Exemption: – $27,220,000
Subject to Estate Tax: $27,780,000
Estate Tax (40%): $9,112,000
Let’s say that this couple chooses to use an ILIT to purchase a second-to-die life insurance policy with a death benefit of $15,000,000 and $100,000 annual premium for 10 years. Each year, the couple gift $100,000 to the ILIT to pay the policy premiums and keep the policy in force. Total premiums paid over 10-years were $1,000,000. However, the couple was able to use their annual gift exclusions of $36,000, so their total gift to the ILIT – or rather, the amount of their lifetime exemption used – was $640,000.
When the second spouse passes away after 10 years, the $15,000,000 death benefit will be distributed to the ILIT, which then allocates these funds per the trust documents. Often, the benefits can replace assets the family used to pay the estate tax, or buy illiquid assets from the estate, providing liquidity to pay the estate tax liability.
In the example above, the estate tax is entirely covered by the death benefit from the life insurance policy – via methods mentioned above – plus additional benefits totaling $5,632,000.
How to Establish an Irrevocable Life Insurance Trust
The process of establishing an irrevocable life insurance trust is relatively straightforward. The trust will apply for coverage on the grantor and the insurance company will provide an offer. The grantor then works with estate planning professionals and lawyers – the lawyers draft the trust documents – to establish an ILIT to be the owner and beneficiary of the policy.
It’s possible to transfer an existing life insurance policy to an ILIT, although this is subject to a three-year lookback period. This means that if the insured parties pass within the first three years of the ILIT, the death benefits of the policy will be brought back into the decedent’s estate.
Key Considerations Before Setting Up an ILIT
ILITs are an extremely valuable estate planning tool, but it’s important for individuals to fully consider the implications of establishing one before setting up an ILIT. Some things to consider include:
By working with experienced estate planning professionals, wealthy individuals can ensure that an ILIT or other estate planning strategies are structured in a manner compatible with the individual’s short and long-term financial goals.
Smith + Howard Wealth Management: Estate Planning Specialists
Estate planning is a complex field that demands the support of experienced advisors. At Smith + Howard Wealth Management, our team takes a comprehensive approach to estate planning.
Our qualified financial planning professionals work hand-in-hand with tax advisors and estate attorneys to craft holistic estate planning strategies that help our clients build a lasting financial legacy.
To explore setting up an ILIT, or to learn more about our services, contact a Smith + Howard Wealth Management professional today.
Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.
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