The primary reason for purchasing life insurance is to ensure that upon passing, our loved ones will have enough money to cover remaining debts and final expenses. It’s also a method for securing our loved ones’ future living costs, at least temporarily. It might seem unjust, therefore, that estate taxes can diminish life insurance proceeds.

Indeed, life insurance proceeds generally fall under federal estate tax (and state estate tax, subject to your state’s laws). This implies that as much as 40% of your life insurance proceeds (currently the highest estate tax rate) could be lost to Uncle Sam rather than reaching your family as planned. This is where estate planning methods, like an irrevocable life insurance trust (ILIT), can be applied.

Typically, all property owned at death is liable to federal estate tax. The crucial point to note is that tax is levied only on property in which you hold an ownership interest; hence if life insurance isn’t owned by you, it will usually dodge the tax. This raises the question: who should be the owner of your life insurance? The answer for many is an irrevocable life insurance trust, or ILIT.

Irrevocable Life Insurance Trust Explained An ILIT is essentially a trust created to hold one or more life insurance policies. The primary objective of an ILIT is to evade federal estate tax. Correctly drafted and funded, your loved ones should receive all of your life insurance proceeds, untouched by estate tax.

Functioning of an ILIT The ILIT, being an irrevocable trust, is perceived as a separate entity. If the ILIT holds your life insurance policy, you don’t own it — the trust does.

The ILIT is designated as the beneficiary of your life insurance policy. (Your family will ultimately receive the proceeds as they are the named ILIT beneficiaries.) This guarantees there’s no risk of the proceeds being tangled in your estate. This could occur, for instance, if your policy’s named beneficiary dies and then you pass away before appointing a new beneficiary.

As neither you own the policy nor your estate is the beneficiary of the proceeds, your life insurance will bypass estate taxation.

An ILIT, being irrevocable, cannot be undone or have its conditions altered after the trust agreement is signed.

Establishing an Irrevocable Life Insurance Trust The initial step is crafting and signing an ILIT agreement. Precise drafting is crucial, which means an experienced attorney should be hired. Although legl fees will be incurred, the value of potential estate tax savings should more than compensate for this expense.

Naming the Trustee

The trustee should be chosen carefully. They are responsible for administering the trust. Neither you nor your spouse should act as trustee, as this might connect the life insurance proceeds back into your estate. Select an individual who understands the trust’s purpose and is willing and capable of performing trustee duties. A professional trustee, such as a bank or trust company, could be a wise choice.

An ILIT’s key duties include:

  • Maintaining a trust checking account
  • Obtaining a taxpayer identification number for the trust entity, if necessary
  • Applying for and purchasing life insurance policies
  • Accepting funds from the grantor
  • Sending Crummey withdrawal notices
  • Paying premiums to the insurance company
  • Making investment decisions
  • Filing tax returns, if necessary
  • Claiming insurance proceeds at your death
  • Distributing trust assets according to the terms of the trust Funding an ILIT

There are two ways to fund an ILIT:

Transfer an existing policy — You can transfer your existing policy to the trust, but note that under federal tax rules, there’s a three-year wait for the ILIT to be effective. This means that if you die within three years of the transfer, the proceeds will be subject to estate tax. Your age and health should be considered when deciding whether to take this risk.

Set up a new life insurance policy — To avoid the three-year rule, you can can purchase a new policy on your life, on behalf of the trust. You cannot make this purchase yourself; you must transfer money to the trust and let the trustee pay the initial premium. Then, as future annual premiums come due, you continue to make transfers to the trust, and the trustee continues to make the payments to the insurance company to keep the policy in force.

Gift Tax Consequences

As an ILIT is irrevocable, any cash transfers you make to the trust are deemed taxable gifts. However, if the trust is created and administered properly, transfers of $18,000 (in 2024, $17,000 in 2023) or less per trust beneficiary will be free of federal gift tax under the annual gift tax exclusion.

In addition, each of us has a gift and estate tax applicable exclusion amount, so transfers that do not fall under the annual gift tax exclusion will be free of gift tax to the extent of your available applicable exclusion. The gift and estate tax applicable exclusion amount is equal to the basic exclusion amount of $13,610,000 (in 2024; $12,920,000 in 2023) plus any applicable deceased spousal unused exclusion amount. Both the annual exclusion and the basic exclusion amount are indexed for inflation and may change in upcoming years.

Crummey Withdrawal Rights

Usually, a gift must have present interest in order to qualify for the annual gift tax exclusion. Gifts made to an irrevocable trust, like an ILIT, are often considered future interest gifts and do not qualify for the exclusion unless they fit an exception. One such exception is when the trust beneficiaries have the right to demand, for a limited period, any amounts transferred to the trust. This is known as Crummey withdrawal rights or powers. To qualify your cash transfers to the ILIT for the annual gift tax exclusion, you must grant the trust beneficiaries this right.

The trust beneficiaries must also receive actual written notice of their rights to withdraw whenever you transfer funds to the ILIT, and they must be provided reasonable time to exercise their rights (30 to 60 days typically). Providing notice to each beneficiary is the trustee’s duty.

Naturally, to protect the trust’s purpose, the trust beneficiaries should not actually exercise their Crummey withdrawal rights; they should let their rights lapse.