ILITs: When an Irrevocable Life Insurance Trust Still Makes Sense

Key takeaways

Life insurance owned by the insured is included in the taxable estate; a policy owned by an ILIT from inception is not, which matters only above the $15 million per person exemption.
An ILIT still earns its keep for estates above the exemption, illiquid estates that need cash at death, second marriages, and beneficiaries who should not receive a large sum outright.
Transferring an existing policy to an ILIT starts a three-year clock; die within it and the proceeds come back into the estate.
An ILIT that no longer serves a purpose can be simplified, decanted, or allowed to lapse with the policy, but only after checking what the trust document permits.

For decades, the irrevocable life insurance trust was the standard companion to a large life insurance policy. The logic was simple. A policy owned by the insured is part of the taxable estate, so a $5 million death benefit in a family already at the exemption produced $2 million of estate tax. Put the policy in a trust the insured didn't own or control, and the problem went away. With the exemption now $15 million per person and permanent, that reason applies to a small fraction of the families who once needed it. The trust still has uses. It also has a maintenance burden a lot of families are carrying for nothing.

How an ILIT works

The insured creates an irrevocable trust with a trustee other than themselves, and the trust applies for and owns the policy from the start. Each year the insured gives the trust money to pay the premium. Those gifts qualify for the $19,000 annual exclusion only if the beneficiaries have a temporary right to withdraw them, which means a written notice to each beneficiary, the Crummey notice, every single year. The trustee pays the premium. At death, the proceeds go to the trust, outside the estate, and the trustee distributes or holds them under the trust's terms. Those terms can include lending to the estate or buying assets from it, which gets cash to the estate for taxes without the proceeds themselves being taxed.

The insured can't own the policy, can't be the trustee, and can't keep any "incident of ownership," like the right to change beneficiaries or borrow against it. And irrevocable means irrevocable. The grantor can't change the terms later.

Who still needs one

Estates above the exemption. A couple with $40 million and $10 million of life insurance would have $50 million taxable without an ILIT and $40 million with it, saving $4 million of tax. For families in this group the ILIT is still a core tool, and the bigger the policy, the more it matters.

Illiquid estates near or above the line. A business owner or real estate investor whose estate is mostly illiquid may face an estate tax due in nine months with no cash to pay it. An ILIT-owned policy supplies the cash, and the trust's ability to lend to or buy from the estate exists for exactly this. Below the exemption, though, the same liquidity need can be met by a policy owned outright, since there's no tax to keep it away from.

Control over the proceeds. A policy paid to a trust rather than to individuals can hold the money for a young beneficiary, a beneficiary with a disability (a special needs trust), a spendthrift, or a spouse in a second marriage, with the remainder going to children from the first. The blended family plan often uses an ILIT this way even with zero tax exposure, because the insurance is the asset that equalizes the two sides.

Creditor protection. Proceeds in a well-drafted trust are beyond the reach of the beneficiary's creditors and, in a divorce, are usually separate property. Florida also protects life insurance proceeds from the insured's creditors under state law, but not from the beneficiary's.

Generation-skipping planning. A dynasty ILIT that allocates GST exemption to the premium gifts can hold proceeds for grandchildren and beyond without transfer tax at each generation. This is a large-estate tool.

Who no longer needs one

Say a married couple has $6 million of assets and a $2 million term policy. That's an $8 million estate with the policy included, against $30 million of combined exemption. The ILIT they set up in 2008, when the exemption was $2 million, is doing nothing but generating Crummey notices and demanding a trustee's attention once a year. Same story for most ILITs created before 2018, when the exemption doubled, and nearly all created before 2011.

And the maintenance isn't trivial. Missed Crummey notices can turn premium gifts into taxable gifts that require a Form 709. A trustee who resigns or dies has to be replaced under the trust's terms. The policies inside old ILITs are often universal life contracts from the 1990s and 2000s that are underperforming their original illustrations and heading toward lapse. Honestly, reviewing the policy is often more urgent than reviewing the trust.

What to do with an ILIT you no longer need

It depends on the trust document and the policy.

Keep it and simplify. If the policy is worth keeping (a paid-up whole life policy, or term coverage the survivor still needs), continue the trust, make the premium gifts, and send the notices. The trust does no harm.
Let the policy lapse. If the coverage isn't needed anymore, as discussed in our post on life insurance in retirement, the trustee can stop paying and let the policy end, or surrender it for cash value that stays in the trust for the beneficiaries.
Decant or modify. Florida law allows a trustee to decant an irrevocable trust into a new trust with more useful terms, and allows modification by agreement of the beneficiaries or by court order in defined circumstances. An ILIT can sometimes be converted into a general-purpose trust for the beneficiaries.
Sell the policy to the grantor. In some cases the grantor buys the policy back from the trust at fair market value, ending the trust and bringing the policy into the estate on purpose, where it no longer matters. The transfer-for-value rules have to be checked so the proceeds stay income-tax-free.

Every one of these starts with reading the document and, usually, a call to the estate attorney who drafted it or a successor.

The three-year rule

An existing policy transferred to an ILIT gets pulled back into the estate if the insured dies within three years of the transfer, under Section 2035. The trust buying a new policy from the start avoids the rule. For an insured who's older or in poor health, the difference between "transfer the policy" and "have the trust buy a new one" can be the whole benefit, and insurability decides which is even possible.

Where we come in

For clients with existing ILITs, the insurance review covers the policy's health with an in-force illustration, and the estate plan review covers whether the trust still has a job. For most families under the exemption, our recommendation is to evaluate the policy on its own merits and stop treating the trust as a tax structure. For the minority above the exemption, or with the control and liquidity needs described above, the ILIT is still the right tool, and we coordinate the premium gifts, notices, and trustee work with the attorney each year. We sell no insurance, so whether a policy belongs in the plan at all gets answered before the question of who should own it.

Frequently asked questions

Can my spouse be the trustee?

Yes, if the spouse isn't the insured and the trust is drafted to avoid giving the spouse powers that would pull the proceeds into the spouse's estate. An independent trustee is cleaner for second-to-die policies and blended families.

What about a second-to-die policy?

A survivorship policy paying at the second death is the classic ILIT policy for estate tax liquidity, since the tax comes due at the second death under the marital deduction. It belongs in an ILIT for the same reasons and is unnecessary for the same families.

Are the premium gifts taxable?

Not if they're within the annual exclusion per beneficiary and the Crummey notices go out. Gifts above the exclusion use lifetime exemption and require a gift tax return.

Does Florida tax the proceeds?

Florida has no estate or inheritance tax. The federal rules are the whole analysis, which is why Florida families are among the least likely to need an ILIT for tax.

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.