Locked-In for Life: Benefits and Drawbacks of Irrevocable Life Insurance Trusts

Life insurance is just as much a part of a well-rounded estate plan as a will. They are an invaluable tool for providing your heirs with a ready source of liquid funds as part of your estate. The right policy can prevent your executor from having to sell off illiquid assets and property to pay debts and cover expenses related to your passing. 

However, life insurance policies can have significant tax implications for your heirs. One of the tools used to reduce the tax burden on policy beneficiaries is an irrevocable life insurance trust (ILIT). These trusts can be beneficial, but like any other estate planning tactic, they can also have drawbacks when employed incorrectly. 

How Irrevocable Life Insurance Trusts Work

An ILIT is similar to other irrevocable trusts. The person establishing the trust as part of their estate plan, the grantor, creates and funds the trust and names a trustee and beneficiaries. Crucially, once an ILIT is established, it cannot be “revoked” or modified. The terms, beneficiaries, and trustees named by the grantor are static and cannot be changed later. 

The trustee may be the same person named as the grantor’s executor, but not always. The beneficiaries are typically the people who would otherwise bear the costs of the grantor’s funeral or remaining debts. 

The trust will buy or take ownership of a life insurance policy covering the grantor, and the grantor will name the trust as the policy’s beneficiary. The trustee will then pay for this policy with the trust’s funds. Upon the grantor’s death, they will also collect the death benefit and distribute it according to the terms established when the trust was created. 

Tax Benefits of Irrevocable Life Insurance Trusts

Creating a trust is much more time and effort than simply purchasing an insurance policy. So, why do ILITs exist if the result is the same? It’s because a properly designed ILIT can provide significant tax advantages

By placing the policy under the ownership of a trust, it is no longer part of the estate. As such, it will not normally be subject to the same inheritance taxes as the rest of your assets. If you have a large estate, this reduces the risk that your entire insurance benefit goes to taxes instead of your beneficiaries.

Additionally, an ILIT can be set up to grant the trustee permission to buy estate assets with the death benefit instead of delivering it directly to your heirs. Suppose there are not enough liquid assets to cover taxes or other debts. This tactic may allow your heirs to convert illiquid property into cash while ensuring the property remains under your estate’s control. 

Finally, a trust allows you to set terms for how your policy benefit is used. Funds paid directly to life insurance beneficiaries can be spent however the recipients want. However, a trust permits you to dictate how the funds are used, such as limiting them to education or housing costs.

Drawbacks of Irrevocable Trusts

An irrevocable trust is not a perfect estate liquidity solution, of course. There are several restrictions on ILITs that may outweigh the benefits, depending on your circumstances:

  • Inability to modify: An irrevocable trust cannot be changed, nor can the policy within it. You must take particular care to ensure you are satisfied with your policy, trustee, and beneficiaries because you cannot tweak things after the trust is established. 
  • Limits on tax protection: An ILIT only protects death benefits from inheritance taxes once it is at least three years old. If you pass away within three years of establishing the trust, your insurance policy’s benefit may still be taxed as part of your assets.
  • Relevancy: California does not apply a state inheritance tax. As such, your estate must exceed the $12.06 million federal exemption before it will be subject to the 40% tax rate. If your estate is not that large, an ILIT may not be necessary. 

Should You Add an ILIT to Your Estate Plan?

ILITs can benefit large estates and people who want to retain control over how their policy’s benefit is spent. However, it is critical to work with an experienced estate planning attorney before deciding to add an ILIT to your estate plan. At The Dayton Law Firm P.C., we spent decades helping California families create estate plans that fit their needs. Call or email us today to discuss your situation and learn more about whether an ILIT is appropriate for your needs.