What Is a Life Insurance Trust and Do You Need One?

An irrevocable life insurance trust, or ILIT, is an estate planning tool that removes your life insurance from your taxable estate. While most Florida families don't need one, understanding how ILITs work can help you determine if this strategy makes sense for your situation.

How an ILIT Works

When you create an ILIT, you transfer ownership of your life insurance policy to the trust. The trust becomes both the owner and the beneficiary of the policy. When you pass away, the death benefit is paid to the trust, which then distributes the funds to the trust beneficiaries according to the terms you've set up.

Because you no longer own the policy, its death benefit is not included in your taxable estate. For estates large enough to face federal estate taxes (currently over $13 million for individuals), this can save hundreds of thousands or even millions in taxes.

Who Needs an ILIT

The primary reason to create an ILIT is estate tax avoidance. If your total estate — including your life insurance death benefit — exceeds the federal estate tax exemption, an ILIT can remove the life insurance proceeds from your estate. Florida has no state estate tax, but the federal estate tax applies at rates up to 40 percent on amounts above the exemption.

Even if your estate is below the current exemption, an ILIT might make sense if you expect your estate to grow significantly, if Congress reduces the estate tax exemption in the future, or if you want to protect the life insurance proceeds from creditors or divorce claims against your beneficiaries.

Important Rules and Limitations

An ILIT is irrevocable — once you create it and transfer the policy, you can't take it back or change the terms without the consent of the trust beneficiaries. You also can't be the trustee of your own ILIT. You'll need to appoint a trusted person or institution as trustee.

If you transfer an existing policy to an ILIT, there's a three-year lookback rule. If you die within three years of the transfer, the policy proceeds are still included in your taxable estate. To avoid this, many people have the ILIT purchase a new policy rather than transferring an existing one.

You'll also need to follow specific procedures for paying premiums. Since the trust owns the policy, premium payments are technically gifts to the trust, and you'll need to send "Crummey letters" to beneficiaries each time you make a premium payment to qualify for the annual gift tax exclusion.

Do Most People Need an ILIT?

For the vast majority of Florida families, an ILIT is unnecessary. If your total estate is well below the federal exemption, the complexity and cost of setting up and maintaining an ILIT outweigh the benefits. A simple beneficiary designation works fine for most families.

An ILIT is a powerful estate planning tool for the right situation — typically high-net-worth families with estates that exceed or approach the federal estate tax exemption. For most families, simpler beneficiary strategies work just fine. Consult with an estate planning attorney to determine the best approach for your situation.