An irrevocable life insurance trust (ILIT) is a financial tool that manages your life insurance policy separately from your estate and distributes funds after you pass away.

You can use an ILIT to ensure your life insurance policy’s death benefit is distributed according to your wishes. An ILIT also offers tax benefits if you’re a high earner.

Since you can’t alter an ILIT once established, it’s essential to understand how they work before you pursue one. Read on to learn how an irrevocable life insurance trust functions and whether it might make sense for your situation.

How does an ILIT work?

Each ILIT involves three distinct parties: grantors, trustees, and beneficiaries.

• Grantor: The grantor is the insured person who establishes the ILIT and identifies the beneficiary or beneficiaries.
• Trustee: The trustee must be someone other than the insured, usually a friend or family member. The trustee is responsible for managing the trust and making distributions to the beneficiaries.
• Beneficiary: Beneficiaries receive the death benefit from the trust, according to the terms outlined by the grantor and enforced by the trustee.

Suppose you, as the grantor, already have a life insurance policy when you set up the trust. In that case, you start by transferring ownership to the trust. Keep in mind you could face a lookback period of three years after transferring a life insurance policy into the ILIT. The death benefit could be taxable if you pass away during this lookback period.

If you’ve yet to identify the right type of life insurance, you can decide which policy is best for your situation and pay into the trust to purchase it as the policyholder with you as the insured. Instead of paying premiums directly, you’ll continue to make payments to the trust. The trustee then uses those funds to pay life insurance premiums.

When you die, the trustee allocates funds to beneficiaries according to your trust document. Without a trust, life insurance beneficiaries can use death benefits however they want to. Your trust document gives you discretion over the funds.

It’s important to note that an ILIT is not the same as making a trust your life insurance beneficiary. Like an ILIT, a trust can help you retain control over how your death benefits are spent. However, a standard trust sometimes offers a different level of protection than an ILIT. With an ILIT, you hand over ownership of the trust to another party, exempting it from estate taxes. You retain ownership over a trust, so it may still face estate taxes.

Why would someone use an irrevocable life insurance trust?

Many people who hope to leave substantial financial legacies use ILITs as estate planning tools. Significant taxes affect estates valued at $12.92 million or more, according to the IRS estate tax filing threshold for 2023. If you retain any ownership over your life insurance policy, its death benefit falls into your taxable estate. When you relinquish your life insurance policy to an ILIT, it’s no longer part of your estate. That way, your beneficiaries receive their full death benefit.

An ILIT can also help you exercise discretion over your death benefit. The trust document can include a detailed outline of your death benefits’ intended use. Those instructions dictate how your trustee allocates and manages those funds.

Suppose you’re leaving funds for grandchildren or others who may be minors or have any dependents with special needs. In that case, this feature is especially useful. You could dictate, for example, whether funds should go toward tuition, a mortgage, or ongoing support.

Benefits and drawbacks of an irrevocable life insurance trust

Irrevocable life insurance trusts can play a central role in end-of-life planning in certain circumstances. However, ILITs may not be the right fit for every family, and they’re very difficult to dissolve if you decide you no longer want one. Therefore, it’s crucial to understand all the potential advantages and risks of establishing an ILIT before you contact an estate planning lawyer to set one up.

Benefits of an irrevocable life insurance trust

• You can minimize the tax burden for the estate: ILITs can maximize your beneficiaries’ payout when you pass away by minimizing what they’ll hand over in taxes. Various taxes can come from large estates, leaving your heirs with a much smaller inheritance than intended. In addition to estate taxes, you may face regulatory taxes like the generation-skipping transfer tax, which makes it harder to leave money to grandchildren and great-grandchildren. With an ILIT, your life insurance policy is insulated from estate taxes because you no longer own it. Your beneficiaries, in turn, can receive their full payouts.
• You decide how loved ones use the death benefit: Typical life insurance policies give beneficiaries complete control over their death benefits, but that may not make sense for every family. With an ILIT, you can play an active role in determining how your loved ones use your death benefits, so you can help plan for their futures. For example, if you know a dependent will need long-term care but may not be able to manage their death benefit alone, you can include that in your trust document.

Drawbacks of an irrevocable life insurance trust

• You can’t change the terms of the trust: While ILITs offer you more control over your death benefit in many ways, they also have a significant restriction. Once you finalize the terms of your trust and hand over ownership to your trustee, you can’t make any modifications. While you continue to pay premiums, your trustee owns the policy. You permanently lose access to the funds and resources that go into your ILIT, even if your life circumstances change drastically.
• You can’t switch beneficiary designations: Once the ILIT is established, you can’t remove, add, or switch beneficiaries. If you assign your partner as the primary beneficiary but you go through a divorce, they’ll still receive your death benefit. You can only cancel an ILIT with a court order and under extreme circumstances.

Establishing and managing an ILIT is highly complex, and the benefits aren’t always worth the difficulty for the average family.

Does an ILIT make sense for you?

Irrevocable life insurance trusts are complicated and must be executed almost perfectly for you and your family to reap the benefits. Families who don’t have to worry about estate taxes or want life insurance to cover final expenses and debts are unlikely to need a tool like an ILIT.

A financial professional or estate planning attorney can help you determine if an ILIT is right for you. If you’re interested in understanding which type of life insurance best suits your unique family and financial situation, contact a licensed insurance agent at Fidelity Life today. You can also start by getting a quote online.