An irrevocable life insurance trust (ILIT) is a special trust that serves as both the owner and beneficiary of one or more life insurance policies. It is primarily a financial planning and estate planning tool that is used to protect assets (specifically a large life insurance death benefit) from being subject to estate taxes.
An ILIT may be right for you and your family if you have a high net worth and want to reduce your estate taxes in the future.
What You Should Know About Estate Taxes
In the United States, you have the right to transfer your property and assets to a beneficiary or beneficiaries after your death.
While you have that right, the federal government and certain states hold the right to tax the value of that property. The estate tax is collected against the fair market value of your property upon its transfer, if the value of your estate is high enough. While you won't pay the tax while you're alive, your estate might.
If your estate is subject to estate taxes upon your passing, the amount that your beneficiaries will ultimately receive may be greatly reduced. Most people prefer not to pay more in taxes than they absolutely need to, even after death, so for those families whose wealth may be subject to estate taxes, proper estate planning is crucial.
Understanding Exclusions and Exemptions
A will and adequate estate planning are crucial for anyone who wants to control where their property goes. But planning for possible estate taxes is essentially limited to families of a certain net worth, because of the current estate tax exemption limits and exclusions.
The marital exclusion dictates that surviving spouses who are U.S. citizens are eligible to receive an unlimited marital deduction, meaning that no estate tax will be due on any property or assets—including proceeds from life insurance policies—when transferred to a surviving spouse. There is also no limit on the amount of property that can be transferred to your spouse, either during your lifetime or after.
Due to the marital exclusion, estate taxes are not part of the estate planning equation until the surviving spouse passes away.
With the federal estate tax exemption, many families do not need to worry about paying estate taxes on transferred property, even upon the death of the surviving spouse. The estate tax exemption is the value of property, in terms of U.S. dollars, that a person can transfer to beneficiaries before the estate tax applies. It is essentially the amount that any one person can leave to others after death that will be free from estate tax. That exemption amount has been rising for years. It's at $12.06 million in 2022.
Both spouses are entitled to the exemption, and the first to die can pass on any unused portion to the survivor. So it may be time to start talking about estate tax reduction strategies if your and your spouse'sjoint net worth and gross estate value is projected to be above $24.12 million, or $12.06 million each. This may include an ILIT.
While estates valued at less than $12.06 million are not currently subject to federal estate taxes for 2022, this threshold generally changes yearly and could change drastically when the Tax Cuts and Jobs Act expires on December 31, 2025.
What Is an ILIT?
An irrevocable life insurance trust is an estate planning tool that allows for the possible exclusion of life insurance proceeds from the estate tax by acting as boththe owner and beneficiary of life insurance policies.
If the legal owner of a large life insurance policy passes away, and their gross estate value is greater than the current estate tax exemption, then the death benefit from the policy would likely be subject to steep estate taxes. But with the ILIT serving as both owner and beneficiary, it essentially acts as an estate tax-shielding "middle man" between a life insurance death benefit and its intended beneficiaries.
In order for the life insurance proceeds to benefit those intended—perhaps the deceased's children—the ILIT has beneficiaries for whom the trustee will invest and administer the proceeds from the policy.
While an ILIT can help in transferring large life insurance proceeds estate tax-free and providing the cash to pay any applicable estate taxes on the rest of the estate, it does come with some disadvantages.
The Downsides of ILITs
By definition, an ILIT is irrevocable, which means once it's in place it cannot be reversed or amended. This is the key drawback to establishing an ILIT, because we all know that life and circumstances change frequently. But it's this very characteristicof ILITs that excludes the life insurance proceeds from estate taxes.
Since the trust is the owner of the insurance policies and cannot be revoked, the insured cannot be deemed as having incidents of ownership, which determines whether or not an asset can be subject to estate taxes.
Other drawbacks of ILITs include their complexity and the costs associated with not only establishing the trusts but also managing and maintaining them. Even so, for families whose estates are large enough to be potentially subject to estate taxes, an ILIT is something worth considering.
You should monitor your life insurance contract regularly to ensure that the policy does not lapse.
Would Your Family Benefit From an ILIT?
Since the primary purpose of an ILIT is estate tax reduction, consider whether—and the extent to which—your estate will be exposed to state and federal estate taxes upon your and your spouse's deaths. That is important if your net worth is at or near the federal exemption limit.
Because the estate tax rules undergo frequent changes, and your net worth itself may fluctuate greatly over time, you may need to periodically revisit a previous decision to forgo an ILIT. This is where an estate planning attorney and/or a financial planner can be of assistance.
How to Set Up an ILIT
If you decide that an ILIT is the best tax-reduction strategy for your family, you’ll need to work with an attorney to set up the trust. Ideally, you’ll select a lawyer who specializes in estate planning. In order to draft the trust document and put your estate plan in place, you must make several decisions, including the following:
- Who will be the trustee of the trust?
- Who will be the beneficiary of the life insurance proceeds?
- Will you be buying a new life insurance policy inside the trust, or will you be transferring an existing policy?
Once you make these decisions, you cannot change them, unlike with a revocable living trust. With an ILIT, you lose virtually all flexibility.
On the other hand, as long as you live at least another three years after you transfer a life insurance policy to the ILIT (no minimum longevity is required for policies the trust itself purchases), all of your life insurance proceeds will pass outside of your estate, potentially saving it a sizable tax bill.
- An irrevocable life insurance trust (ILIT) is a tool that is used to protect assets—specifically a large life insurance death benefit—from being subject to estate taxes.
- ILITs are generally used by families with a high net worth and gross estate value.
- An ILIT can help transfer large life insurance proceeds estate tax-free and provide the cash to pay any applicable estate taxes.
- The key drawback of an ILIT is that it's irrevocable, which means it can't be reversed or amended.
If you are the owner and insured, then the death benefit of a life insurance policy will be included in your gross estate. However, when life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and thus not subject to state and federal estate taxation.How does an irrevocable trust avoid taxes? ›
Assets transferred by a grantor to an irrevocable trusts are generally not part of the grantor's taxable estate for the purposes of the estate tax. This means that the assets will pass to the beneficiaries without being subject to estate tax.Does an irrevocable life insurance trust have to file a tax return? ›
The ILIT has its own federal tax identification number and must file annual state and federal income tax returns, although it usually has no taxable income while you are alive.Why would you put life insurance in an irrevocable trust? ›
An ILIT provides a number of advantages beyond the ability to provide a tax-free death benefit. This includes protecting your insurance benefits from divorce, creditors and legal action against you and your beneficiaries. An ILIT also avoids probate and shields assets from expense and loss of privacy during probate.Are Ilit proceeds taxable? ›
An Irrevocable Life Insurance Trust (ILIT) is commonly used to prevent the taxation of life insurance proceeds after the death of the insured person. Although life insurance proceeds are not subject to income tax, they are includable in the taxable estate of the insured.Are life insurance proceeds considered income in an irrevocable trust? ›
Trust Ownership of the Policy
By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 40%.
The downside to irrevocable trusts is that you can't change them. And you can't act as your own trustee either. Once the trust is set up and the assets are transferred, you no longer have control over them.What is the greatest advantage of an irrevocable trust? ›
An Irrevocable Trust means you can protect yourself, your loved ones and your estate against future legal action. It also means you can protect the financial future of your estate by avoiding substantial estate taxes.How do I get around estate tax? ›
- Give gifts to family. One way to get around the estate tax is to hand off portions of your wealth to your family members through gifts. ...
- Set up an irrevocable life insurance trust. ...
- Make charitable donations. ...
- Establish a family limited partnership. ...
- Fund a qualified personal residence trust.
Income Tax Treatment of Irrevocable Trusts
The trustee of an irrevocable trust must complete and file Form 1041 to report trust income, as long as the trust earned more than $600 during the tax year. Irrevocable trusts are taxed on income in much the same way as individuals.
This rule generally prohibits the IRS from levying any assets that you placed into an irrevocable trust because you have relinquished control of them. It is critical to your financial health that you consider the tax and legal obligations associated with trusts before committing your assets to a trust.How are beneficiaries of an irrevocable trust taxed? ›
When an irrevocable trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary's distribution that's interest income as opposed to principal.What is the difference between an irrevocable trust and an ILIT? ›
An ILIT is an irrevocable trust that contains provisions specifically designed to facilitate the ownership of one or more life insurance policies. The ILIT is both the owner and the beneficiary of the life insurance policies, typically insuring the life of the person or persons creating the ILIT, known as the grantor.What happens to Ilit after death? ›
If you own a life insurance policy when you die, it is included as part of your gross estate for federal estate tax purposes. However, if an ILIT owns the policy, the proceeds of the policy will pass outside of your estate to the beneficiaries of the ILIT, which can be your spouse, or your children, or anyone really.Who should be the owner of an irrevocable life insurance trust? ›
Typically, the initial Trustee of an Irrevocable Life Insurance Trust is a relative, close family friend, or a trusted advisor, such as your CPA, with the surviving spouse becoming Trustee or Co-Trustee after your death. 8.Do beneficiaries pay taxes on irrevocable trust distributions? ›
Irrevocable trust: If a trust is not a grantor trust, it is considered a separate taxpayer. Taxable income retained by the trust is taxed to the trust. Distributed income is taxed to the beneficiary who receives it.Is money distributed from an irrevocable trust taxable? ›
Irrevocable trust distributions can vary from being completely tax free to being taxable at the highest marginal tax rates, and in some cases, can be even higher.How do I avoid tax on life insurance proceeds? ›
- Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them.
- However, any interest you receive is taxable and you should report it as interest received.
One fundamental tax-focused decision when structuring a trust is whether the trust should be a grantor trust or a non-grantor trust. If the former, the grantor will be responsible for paying the income tax on income (including capital gains) produced by the trust assets. If the latter, the trust will pay its own taxes.What happens to capital gains in an irrevocable trust? ›
Capital gains are not considered income to such an irrevocable trust. Instead, any capital gains are treated as contributions to principal. Therefore, when a trust sells an asset and realizes a gain, and the gain is not distributed to beneficiaries, the trust pays capital gains taxes.
at the insured's death, the policy proceeds are paid to the trust. an IlIt removes the life insurance proceeds from the gross estate, thus reducing the taxable estate.How do I get around an irrevocable trust? ›
The two most common ways to terminate and/or modify an irrevocable trust is to 1) argue that there has been a change of circumstances not anticipated by the settlors at the time they created the trust (for example changes in tax law, and 2) argue that all beneficiaries consent to the proposed termination and or ...Can a trustee withdraw money from an irrevocable trust? ›
The trustee of an irrevocable Trust cannot withdraw money except to benefit the Trust. These terms include paying maintenance costs and disbursement income to beneficiaries. However, it is not possible to withdraw money for personal or business use.How hard is it to break an irrevocable trust? ›
As discussed above, irrevocable trusts are not completely irrevocable; they can be modified or dissolved, but the settlor may not do so unilaterally. The most common mechanisms for modifying or dissolving an irrevocable trust are modification by consent and judicial modification.Can you put a bank account in an irrevocable trust? ›
One or more deposit accounts in the name of an irrevocable trust are insured up to $250,000 for the “non-contingent trust interest” of each beneficiary. Separately, funds representing “contingent interests” are insured up to $250,000 in the aggregate.Is an irrevocable trust worth it? ›
Irrevocable trusts are an important tool in many people's estate plan. They can be used to lock-in your estate tax exemption before it drops, keep appreciation on assets from inflating your taxable estate, protect assets from creditors, and even make you eligible for benefit programs like Medicaid.What happens to an irrevocable trust when the beneficiary dies? ›
The state of California has an anti-lapse law that is put in place in the event that a beneficiary passes away before the decedent. With this statute, the beneficiary's share of the estate will pass down to the beneficiary's heirs or issue, rather than reverting back to the decedent's estate.How do rich people avoid estate tax? ›
More from Year-End Planning:
By shifting any future appreciation out of their estate, the wealthy can avoid or reduce estate taxes at death. The investment growth becomes a tax-free gift to heirs. Absent growth, the asset simply passes back to the owner without a transfer of wealth.
The federal estate tax exemption shields $12.06 million from tax as of 2022 (rising to $12.92 million in 2023). 2 There's no income tax on inheritances.Who bears the tax burden of an estate? ›
Most estimates assume the decedent bears the estate tax, primarily because of data limitations. There is good reason to believe that heirs most often bear the tax. When the burdens are analyzed this way, individuals inheriting over $1 million bear almost all of the burden of the estate tax.
In 2022, irrevocable trusts pay tax at the top tax bracket of 37% when undistributed taxable income is $13,450. Individual beneficiaries pay tax at the top tax bracket when taxable income is $539,900 for singles and $647,850 for married individuals filing jointly.Who files tax return for irrevocable trust? ›
The fiduciary of a domestic decedent's estate, trust, or bankruptcy estate files Form 1041 to report: The income, deductions, gains, losses, etc. of the estate or trust.What state is an irrevocable trust taxed in? ›
California is unique in that it first taxes a trust if the trust has a California trustee; if not, it then looks to the residence of the non-contingent beneficiaries. California tax on a trust's income can be reduced if a trust with some or all non-resident beneficiaries has a non-resident trustee.Is irrevocable beneficiary included in gross estate? ›
It is the only instance when life insurance proceeds are exempt from estate tax. Hence, designating your heirs as the irrevocable beneficiary exempts the proceeds from estate tax. It is, therefore, the wiser move.What are excluded from gross estate? ›
"Gross estate" is a term used to describe the total dollar value of an individual's assets at the time of their death. A gross estate value does not consider his figure debts owed and tax liabilities.Are life insurance proceeds excluded from gross income or included? ›
Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them. However, any interest you receive is taxable and you should report it as interest received.Is an irrevocable grantor trust included in gross estate? ›
Property transferred to an irrevocable living trust does not count toward the gross value of an estate. Such trusts can be especially helpful in reducing the tax liability of very large estates.