What Advisors Should Know About Irrevocable Life Insurance Trusts

Coryanne Hicks

Death and taxes may be certainties of life, but how much tax your family pays upon your death is still within your control to a certain degree.

The federal estate tax exemption under current law is $11.58 million for individuals and $23.16 million for married couples. With exemptions at the highest they've ever been, most people don't need to be concerned about federal estate taxes, with one glaring caveat.

The current law will sunset in 2025 and revert to the old law, resulting in the exemption being "basically cut in half," says Ray Radigan, head of private trust at TD Wealth. There is also the potential wrench with the results of Election 2020, which could impact estate tax exemption laws.

So to say there is no need for asset protection would be an oversight on the part of many financial advisors. Like insurance, tax shelters can still be worth putting in place, even if tax laws change in your clients' favor.

One asset protection strategy is an irrevocable life insurance trust, or ILIT.

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What Is an Irrevocable Life Insurance Trust?

"An irrevocable life insurance trust is a type of trust that is specifically designed to hold a life insurance policy so the proceeds of the policy avoid estate tax," says Jason Field, financial advisor at Van Leeuwen & Company. It is a form of living trust that cannot be dissolved or revoked unless failure to pay premiums causes the insurance policy held by the trust to lapse.

"The main advantages of an ILIT are that it can provide immediate liquidity to beneficiaries, and those proceeds are tax-free," says Nick Hatfield, vice president and wealth advisor at EP Wealth Advisors. "Additionally, the value of the ILIT is outside of the estate and not subject to taxable estate calculation."

A key feature of an irrevocable trust is that it transfers ownership of the life insurance policy from the insured to the trust. For this to work properly, the insured cannot own or control the insurance policy.

Instead, "the policy is bought with the ILIT as the owner and the beneficiary, and the grantor being the insured," says Loreen Gilbert, CEO and founder of WealthWise Financial Services. The insured also cannot be the trustee of the trust. Usually, the trustee is a family member, with the insurance premiums being paid through annual gifting from the insured to the trust, she says.

If all goes as planned, upon the insured's death, the ILIT will distribute the life insurance proceeds tax-free to the beneficiaries.

Radigan illustrates this with an example: Suppose your client has assets worth $15 million and purchases a life insurance policy that pays a $5 million death benefit to her children. When your client dies, she would have a taxable estate of $20 million, which in 2020, would incur about $3.3 million in federal estate taxes.

If that $5 million insurance policy were owned by an ILIT instead of your client, the taxable estate would be $15 million, reducing the federal estate taxes in 2020 to about $1.3 million.

"In other words, this estate saved $2 million by simply having the ILIT own the $5 million life insurance policy," Radigan says.

But what if the estate tax exemption goes down before your client dies? If this happens, no harm no foul: "If the estate tax exemption goes down, and your client has already funded an ILIT, that asset is safe from estate taxes," Gilbert says.

Those assets are also safe from your beneficiary's creditors as long as they remain in the trust.

What Financial Advisors Need to Know About ILITs

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ILITs are not without their drawbacks, perhaps the biggest being their complexity. The challenge with ILITs is to structure them in a way that the annual contributions, which cover the insurance premiums qualify for the $15,000 gift tax exclusion.

To do this, "attorneys will often include what is called a Crummey power when drafting an ILIT," says Brian Bruggeman, vice president and director of financial planning at Baker Boyer Bank. The Crummey power allows the insured to pay the trust for the premium on her insurance policy without reducing her lifetime gift tax exemption amount, but it also means beneficiaries must understand the purpose of the ILIT so they don't inadvertently run afoul of any rules.

Likewise, whenever a contribution is made, Crummey letters must be sent to the beneficiaries "letting them know of the gift to the trust and that they have the right to withdraw the money," Gilbert says. If the beneficiaries then take the money out, the insurance policy could collapse.

This points to another drawback, namely that the insurance premiums for the policy must continue to be paid until death; otherwise, the policy could lapse, causing the trust to dissolve, Field says.

Your client must be committed to keeping the policy over a long period. "The cost of insurance associated with a permanent life insurance policy generally rises over time, so to keep the policy from lapsing, clients need to be able to fund the policy appropriately," Bruggeman says.

And even though your client is the one paying the premiums, she will have no control over the life insurance policy, meaning she can't change or designate a beneficiary or increase or decrease the policy.

Age is another consideration.

"There is a three-year look back for existing insurance policies that are given into the ILIT, so the grantor must be alive for three years after the insurance policy is given to the ILIT for it to remain outside the estate," Gilbert says. This does not apply for a new policy established in the ILIT and does not apply if the ILIT purchases the policy from the grantor.

Having the trust purchase the life insurance policy for the policy's interpolated terminal reserve, a fancy way of saying the policy's fair value can be one way to avoid both the three-year rule and reduce your client's lifetime taxable gift exclusion, Bruggeman says.

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When to Use an ILIT

Given these complexities and potential drawbacks, the question becomes are ILITs ever worth the effort? The answer is still a qualified is yes.

"Anyone with a net worth of more than $5 million, who has permanent life insurance policies for a death benefit, should consider an ILIT," Gilbert says. The exception to this is if the insurance policy is intended to supplement retirement income, in which case, it should not go into an ILIT.

Irrevocable trusts can also be ideal estate planning tools for successful business owners. If the majority of your client's wealth is tied up in his or her business, there may not be enough liquidity to pay estate taxes. This may force the heirs to sell part of the business to cover the taxes, Bruggeman says.

An ILIT can be a viable solution in such situations. Since the death benefit is paid to the ILIT free of estate tax, the trust can distribute the death benefit outright to beneficiaries, who can use the proceeds to pay the estate taxes, Radigan says.

ILITs can also be used for clients who want to help their heirs with taxes due on inherited individual retirement accounts now that the stretch IRA, which allowed nonspousal beneficiaries to stretch withdrawals of inherited assets over the beneficiary's lifetime, is no longer an option, Hatfield says.

"In the end, an ILIT can be a very beneficial structure to save estate tax, but advisors must be careful and ensure that the trust is drafted and administered correctly to maximize the benefit and minimize any risk," Radigan says.