An ILIT can protect life insurance proceeds from estate tax

Life insurance is a vital part of many estate plans. It provides the necessary cash to cover estate taxes, debts, and other financial obligations your loved ones might face. But here’s something you might not know: if you own your life insurance policy directly, the proceeds will likely be included in your taxable estate.

For those with a sizable estate (or one that could grow significantly), this can create a major tax headache. You'll want to explore smart strategies to protect those insurance proceeds. One powerful option to consider is an Irrevocable Life Insurance Trust, or ILIT. An ILIT effectively removes the policy from your estate, making sure the full death benefit passes to your beneficiaries without being hit by estate taxes.

Let's break down how it works and whether it’s the right solution for your financial goals.

How Does an ILIT Work?

Setting up an ILIT involves a few key steps. You create an irrevocable trust and then either:

• Transfer an existing life insurance policy into it.
• Have the ILIT purchase a new policy as the owner from the start.

You'll also need to fund the trust so it can cover the policy's premium payments.

It’s important to understand that transferring a policy or funding the premiums is considered a taxable gift. The good news is these gifts can often be covered by your lifetime gift and estate tax exemption. You might even be able to structure the ILIT with "Crummey" provisions, which allow you to use your annual gift tax exclusion for the premium payments. For 2025, gifts up to $19,000 are tax-free and don't eat into your lifetime exemption.

The "irrevocable" part is crucial—once the trust is established, you can't change the terms or the beneficiaries. This loss of control is exactly what keeps the policy proceeds out of your taxable estate. You can, however, appoint a trusted family member or a seasoned professional to act as the trustee.

When you pass away, the ILIT is typically the policy's primary beneficiary. The proceeds are paid into the trust and then managed and distributed to your designated beneficiaries, such as your spouse, children, or grandchildren, according to the terms you set.

What Are the Potential Pitfalls?

While ILITs are powerful, they aren't without their complexities. Here are a couple of things to watch out for:

• The Three-Year Rule: If you transfer an existing policy into an ILIT and pass away within three years of the transfer, the IRS will pull the proceeds back into your taxable estate. This rule doesn't apply if the ILIT purchases a new policy from the outset.
• Delaying the Tax Bill: Naming your surviving spouse as the sole beneficiary might just postpone the estate tax problem until their death. It’s a common scenario that needs careful planning to avoid simply kicking the tax can down the road.

Is an ILIT the Best Option for You?

An ILIT isn't a one-size-fits-all solution. It's most beneficial for high-net-worth individuals who are likely to face a significant estate tax bill.

For the right person, an ILIT is an excellent tool. It provides your heirs with tax-free cash exactly when they need it most, preventing them from having to sell off family assets or business interests just to pay taxes.

However, if your estate isn't large enough to trigger significant estate taxes, the benefits of an ILIT might not justify giving up control over the policy.

Let's Find Your Path to Financial Freedom

Navigating the complexities of estate planning requires more than just number-crunching; it demands a strategic partner who understands your unique situation. We can help you weigh the pros and cons and determine if an ILIT is the right fit for your long-term goals.

Ready to make a smart decision for your family's future? Let's talk.