When it comes to estate planning, life insurance is a key tool that allows you to transfer wealth to your beneficiaries without incurring income tax or going through the probate process. However, due to the large cash value and death benefits that life insurance policies often carry, they can attract the attention of creditors. This is where an Irrevocable Life Insurance Trust (ILIT) becomes essential. An ILIT can protect life insurance proceeds from creditors and can also be an effective way to manage estate taxes, making it a valuable asset for preserving wealth.

What Exactly Is an ILIT?

An ILIT is a type of trust specifically designed to own a life insurance policy. Like other trusts, it involves three key parties: the grantor, who sets up the trust; the trustee, who manages it; and the beneficiaries, who receive the benefits. The grantor specifies how the life insurance proceeds will be managed and distributed. For example, the proceeds could be used to generate income, pay off debts, or cover estate taxes, with distributions made to beneficiaries at predetermined milestones.

To fund the ILIT, a grantor with a taxable estate can use their annual gift-tax exclusion or apply a portion of their lifetime gift-tax exemption. As of 2024, the annual exclusion is $18,000 per beneficiary, and the lifetime exemption is $13.61 million per individual. Once the trust is funded, the trustee is responsible for paying the premiums on the life insurance policy. It is also possible to transfer an existing policy into the ILIT, but the grantor must survive at least three years for the proceeds to avoid estate taxes.

The Major Benefits of an ILIT

The key advantage of an ILIT is that it removes life insurance proceeds from the grantor’s taxable estate. As a result, it can reduce the amount of estate tax due upon the grantor’s death, preserving more wealth for the beneficiaries. Since the trust is irrevocable, the grantor no longer controls or owns the assets within it, and creditors typically cannot access the assets in the ILIT. Upon the insured’s death, the life insurance benefit is paid to the ILIT tax-free, and the trustee distributes the proceeds according to the terms of the trust.

Flexible Estate Planning with ILITs

ILITs offer significant flexibility in how assets are distributed. For instance, a parent who wants to ensure that their children have funds for education can specify that a portion of the life insurance benefit be used for this purpose, with distributions triggered when each child reaches certain educational milestones.

This setup allows for gradual and controlled distributions over time, ensuring the funds are used appropriately. The trustee can also be given the discretion to make additional distributions for things like healthcare costs or starting a business as beneficiaries’ needs evolve.

Furthermore, an ILIT can be used to support charitable causes, alongside providing for family members. The grantor may designate that a part of the life insurance proceeds be allocated to charity, and the trustee would ensure that these distributions are made according to the grantor’s wishes.

Expert Guidance for Your Estate Planning

Incorporating an ILIT into your life insurance strategy is just one way to protect your family’s wealth while meeting important estate-planning objectives such as reducing taxes and facilitating efficient wealth transfer. Working with a wealth advisor can help you understand the benefits, costs, and ongoing responsibilities associated with setting up and managing an ILIT. They can guide you through alternatives and help you make informed decisions based on your specific needs and long-term goals.