Irrevocable life insurance trusts

In short

A friend of mine once said the hardest tax bill to plan for is the one that arrives after you are gone. If you own a large life insurance policy, the death benefit can be counted as part of your estate. That can push a big share of it toward the federal estate tax. An irrevocable life insurance trust, often called an ILIT, is built to keep that benefit out of your taxable estate. The trust, not you, must own the policy. You cannot change the deal later, and that is the whole point. Start by talking with an estate attorney, because a small slip in the paperwork can undo the plan.

The whole of it

What it is

I once watched an old rancher hand his son a set of keys and say, "Now it is yours, and I mean it." He did not keep a spare. An ILIT works the same way. It is a trust, which is a legal arrangement where one party holds property for the benefit of another. This one holds a life insurance policy on your life. Irrevocable means the person who set it up cannot cancel it or take the policy back.

The person who creates the trust is called the grantor. The person who manages it is the trustee. The people who will receive the money are the beneficiaries. You, the grantor, give up control. A trusted person or a professional firm acts as trustee.

If you are holding a large policy, you have probably worried about what your family will keep. Here is the problem in plain words. The IRS counts life insurance proceeds in your gross estate if you owned the policy at death, or if you held what the tax code calls incidents of ownership. That phrase means rights such as naming who gets the money or borrowing against the policy. Internal Revenue Code Section 2042 sets this rule. An ILIT takes those rights out of your hands.

How it works

A friend of mine set one up for his two daughters, and he told me the order of events mattered more than anything. The trust comes first. The attorney writes the trust document, and the trustee signs it. Then the trustee applies for a new policy on the grantor's life, so the trust is the owner from day one. That clean start avoids a trap.

Here is the trap. If the grantor transfers an existing policy into the trust and dies within three years, the proceeds are pulled back into the estate. Internal Revenue Code Section 2035 sets that three year rule. Buying the policy inside the trust sidesteps it.

Next comes the money to pay the premiums. The trust has no income of its own, so the grantor makes gifts to it each year. The trustee then pays the insurer. Each gift is a gift in the eyes of the IRS, and a gift must qualify for the annual exclusion to avoid using up lifetime exemption. To qualify, the beneficiaries need a present right to take the gift for a short window. This is called a Crummey power, named after a court case. The trustee sends each beneficiary a written notice, and the beneficiary has a set number of days to withdraw the money. Most let it pass. The notice still has to go out, every year, in writing.

When the grantor dies, the insurer pays the death benefit to the trust. The trustee then follows the trust terms. The money can stay in trust for years, or it can be paid out in stages. Some families use the cash to buy assets from the estate or to lend it money, which helps pay estate tax without forcing a sale of a family business or land.

The numbers, and where to find yours

If you are wondering what the estate tax exemption is today, the figure changes and I will not guess at it. The federal basic exclusion amount is the current figure, which the official source publishes each year. The top federal estate tax rate is the current figure, which the official source publishes each year. The annual gift tax exclusion, which is the per person amount you may give without filing a gift tax return, is the current figure, which the official source publishes each year. The IRS publishes these each year in a revenue procedure and on its estate tax and gift tax pages at irs.gov.

You will also want your own numbers. Look at the face amount of your policy, which is the death benefit. Look at the annual premium. Count your beneficiaries, since each one can receive a gift that uses the annual exclusion. Add up your net worth to see where it sits against the exclusion. Some states also charge their own estate or inheritance tax, with much lower thresholds, so check your state revenue department.

A worked example

Let me tell you about a woman I will call Margaret Ellis. She is 62, a widow, and she owns a trucking company and farmland worth about $40,000,000 together. She wants her three children to inherit without a forced sale.

Margaret has a policy quote for $10,000,000 of coverage. The annual premium is $180,000. She sets up an ILIT, and the trustee buys the policy. Each year Margaret gives the trust $180,000 to cover the premium.

Now the gift math. She has three children and four grandchildren, so seven people hold Crummey rights. Suppose the annual exclusion were $18,000 for illustration. Seven people at $18,000 each is $126,000. That falls short of $180,000. The extra $54,000 is a taxable gift that eats into her lifetime exemption. She reports it on a gift tax return, Form 709. If she added more beneficiaries, the exclusion would cover more. This is why the attorney counts heads before anything is signed.

Say Margaret pays premiums for 20 years. That is $180,000 times 20, which is $3,600,000 in total gifts. If she dies at 82, the trust collects $10,000,000. Had she owned the policy herself, and if the estate were taxed at 40 percent for illustration, the tax on that benefit alone would be $10,000,000 times 0.40, which is $4,000,000. Kept in the trust, that $10,000,000 is not added to her estate. Her children receive $10,000,000 for $3,600,000 of premium gifts, and the estate tax bill is smaller. The trustee can also lend the trust money to the estate to pay the bills that come due.

These are plain figures for a story. Your policy, premium, and tax rate will differ.

Where it goes wrong

I have seen good plans spoiled by small things. The most common one is the grantor keeping a string. If Margaret could change a beneficiary, borrow from the policy, or cancel it, the IRS can say she still held incidents of ownership. The proceeds would come back into her estate. Keeping clean hands matters.

The next problem is the three year rule. Moving an old policy into the trust starts a clock. If death comes inside that window, the benefit is taxed anyway. Buying a new policy inside the trust avoids it, though a health issue can make a new policy costly or hard to get.

Missed notices cause trouble too. If the trustee skips the Crummey letters, the gifts may not count for the annual exclusion. That turns an easy gift into a use of lifetime exemption. Paying a premium from the grantor's personal account, rather than through the trust, can also blur the lines. The money should move as a gift to the trust, then from the trust to the insurer.

Then there is the cost of being wrong about the tax law itself. Congress can change exemption levels. The exclusion has shifted before and the law sets it to change on a schedule, so a plan built for one level may look different later. And the policy has to keep performing. If the insurer raises costs inside a permanent policy, the trust may need more gifts than planned. A trust that lapses for missing premiums protects no one.

Last, the trustee matters. A child who is also a beneficiary can have a conflict. A professional trustee costs money but brings steadiness. Neither choice is wrong. It just deserves thought.

Questions to answer before you leave this page

Have you worked out whether your estate is large enough to face federal estate tax, or a state estate tax with a lower threshold? Who would serve as trustee, and would that person be fair and steady when your family is grieving? Are you ready to let go of control over the policy, knowing you cannot take it back? Will a new policy be available at a price you can carry, given your age and health? Can you make the yearly gifts on time, and who will send the written Crummey notices each year? How many beneficiaries will hold withdrawal rights, and does that count cover the premium? Does your estate attorney know your state rules, and have you asked how the trust fits with the rest of your plan? And if tax law changes, who will review the trust and tell you so?