Tax Tips
The Irrevocable Life Insurance Trust (ILIT): Keeping Your Death Benefit 100% Tax-Free
The Irrevocable Life Insurance Trust (ILIT): Keeping Your Death Benefit 100% Tax-Free
CORE INSIGHTS
- The Ownership Trap: If you own a life insurance policy, the death benefit is part of your taxable estate. This can trigger a 40% Estate Tax. IRC § 2042
- The ILIT Solution: An Irrevocable Trust owns the policy. Since the trust is a separate legal entity, the death benefit sits outside your estate, remaining 100% tax-free.
- Instant Liquidity: Estate taxes are due in 9 months. Real estate is illiquid. An ILIT provides instant cash to pay the IRS, saving family assets from forced sale.
Life Insurance is income-tax-free, but not estate-tax-free. Under IRC Section 2042, any policy you control is includable in your estate. The ILIT is the surgical tool used by the ultra-wealthy to sever this link.
What-If Scenario: The $5 Million Policy
| Ownership | Tax Liability (40%) | Net to Heirs |
|---|---|---|
| Personal | -$2,000,000 | $3,000,000 |
| ILIT | $0 Tax Exempt | $5,000,000 |
Visualizing the Tax Shield
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*Figure 1: Net Death Benefit. Without an ILIT (Red), 40% evaporates. With ILIT (Green), 100% is preserved.*
Strategic Action Steps
1
Draft the Trust First
Do not buy the policy yet. Have an attorney draft the ILIT. The Trust must be the original applicant to avoid the 3-Year Lookback Rule. IRC § 2035
Do not buy the policy yet. Have an attorney draft the ILIT. The Trust must be the original applicant to avoid the 3-Year Lookback Rule. IRC § 2035
2
Establish Checking
The ILIT needs its own EIN and bank account. You gift money to the Trust. The Trustee writes the check for the premium.
The ILIT needs its own EIN and bank account. You gift money to the Trust. The Trustee writes the check for the premium.
3
Send Crummey Letters
The Trustee must send notices to beneficiaries every time you fund the trust. This formality qualifies the gift for the Annual Exclusion.
The Trustee must send notices to beneficiaries every time you fund the trust. This formality qualifies the gift for the Annual Exclusion.
The Bottom Line: Who Should Choose What?
- Use ILIT: Net Worth >$13M (or growing fast). You need liquidity to pay Estate Taxes.
- Personal Owner: Net Worth <$10M. The complexity isn't worth it if you are under the federal exemption limit.
Is Life Insurance subject to Estate Tax?
Yes. If you own the policy, the IRS includes the full Death Benefit in your Gross Estate.
How does an ILIT solve this?
The Trust owns the policy, not you. Therefore, the proceeds are excluded from your taxable estate.
What is the 3-Year Lookback Rule?
If you transfer an existing policy to an ILIT and die within 3 years, it is pulled back into your estate.
Disclaimer: This content is for informational purposes only. ILITs are irrevocable. Consult an attorney.