High-net-worth individuals often face significant estate tax liabilities, mainly when life insurance proceeds are included in the taxable estate. While the federal estate tax exemption is currently $13.61 million per person (as of 2024), assets exceeding this limit are taxed at up to 40%. Without proper planning, heirs may receive a significantly reduced inheritance due to these tax obligations. However, Beck, Lenox & Stolzer states that you can safeguard your financial legacy by understanding how to use an irrevocable life insurance trust for high-net-worth estate planning.
How an Irrevocable Life Insurance Trust (ILIT) Works
An ILIT is a trust that owns a life insurance policy, ensuring that the death benefit remains outside the insured’s taxable estate. Unlike personally owned life insurance policies, which are considered part of an estate for tax purposes, policies held within an ILIT are exempt from estate taxation.
Setting up an ILIT involves three key steps:
- Establishing the trust and appointing a trustee to manage it
- Transferring an existing life insurance policy to the trust or having the trust purchase a new policy
- Ensuring that the trust is adequately funded to cover premium payments
Once the insured passes away, the ILIT receives the life insurance payout and distributes funds to beneficiaries according to the trust’s instructions. This structure allows for controlled wealth distribution, asset protection and estate tax savings.
Benefits of an ILIT for High-Net-Worth Individuals
Without an ILIT, life insurance proceeds are included in the taxable estate, potentially triggering a high estate tax bill. By transferring ownership of the policy to an ILIT, the death benefit avoids estate taxation, maximizing the amount passed to heirs.
Providing Liquidity for Estate Expenses
Many high-net-worth estates include illiquid real estate, business holdings, or investments. When estate taxes and settlement costs arise, heirs may need to sell valuable assets to cover these expenses. An ILIT provides immediate liquidity, ensuring that estate taxes, debts and other costs are covered without forcing the sale of legacy assets.
Controlling How Beneficiaries Receive Funds
ILITs allow the grantor to set specific terms for how and when beneficiaries receive their inheritance. Instead of a lump sum payout, the trust can distribute funds gradually, ensuring financial stability and reducing the risk of mismanagement. ILITs can also be structured to provide income over time, fund education, or support special needs planning.
Protecting Assets from Creditors and Lawsuits
Because an ILIT is a separate legal entity, the funds held within the trust are shielded from creditors, lawsuits, and divorce settlements. This protection ensures that the intended beneficiaries receive the full benefit of the policy proceeds.
Key Considerations When Setting Up an ILIT
The Three-Year Rule
The IRS imposes a three-year lookback period if an existing life insurance policy is transferred into an ILIT. If the insured passes away within three years of the transfer, the policy proceeds will still be counted as part of the taxable estate. To avoid this risk, many estate planners recommend having the trust purchase a new policy rather than transferring an existing one.
Trustee Selection and Responsibilities
Since an ILIT is irrevocable, the trustee plays a crucial role in managing the trust and ensuring compliance with legal requirements. The trustee must handle premium payments, administer distributions and follow the terms of the trust as outlined by the grantor. Many individuals appoint a financial institution or experienced fiduciary to serve as trustees to ensure proper oversight.
Gift Tax Considerations and Premium Payments
Funding an ILIT to pay life insurance premiums requires careful planning to avoid triggering gift taxes. Many grantors use the annual gift tax exclusion ($18,000 per recipient in 2024) to fund premium payments, often by making contributions that qualify as Crummey gifts (yes, that is a real term). These contributions allow beneficiaries to access a portion of the funds temporarily, ensuring compliance with IRS rules while maintaining the trust’s tax advantages.
When an ILIT Is the Right Choice
High-net-worth individuals should consider an Irrevocable Life Insurance Trust if they:
- Have a taxable estate exceeding the federal exemption limit
- Own significant life insurance policies that would otherwise be subject to estate taxes
- Want to ensure controlled wealth distribution to heirs
- Need liquidity to cover estate taxes and settlement costs
- Seek asset protection from creditors and legal disputes
If you’re unsure whether an Irrevocable Life Insurance Trust is the right choice, help is available. Schedule a phone consultation with our estate planning law firm today, and we’ll walk you through your options to help you make the right decisions to preserve your legacy. Our attorneys have additional resources for you, if needed.
Key Takeaways on Irrevocable Life Insurance Trusts for High-Net-Worth Estate Planning
- Reducing estate taxes: An ILIT removes life insurance proceeds from the taxable estate, preventing unnecessary tax liabilities.
- Providing financial security: Life insurance proceeds can be used to pay estate taxes, debts and other expenses without forcing the sale of valuable assets.
- Structuring wealth distribution: ILITs allow for controlled and phased inheritance, reducing the risk of financial mismanagement.
- Avoiding IRS pitfalls: Properly structuring an ILIT, including adhering to the three-year rule and using Crummey gifts, ensures compliance and tax efficiency.
- Choosing the right trustee: A well-managed ILIT requires an experienced trustee to oversee distributions and ensure that the trust operates as intended.
Reference: J.P. Morgan (Nov. 27, 2024) “When Does It Make Sense for a Trust to Own Your Life Insurance Policy?”
