Life insurance trusts: fund or collapse?

An Irrevocable Life Insurance Trust (ILIT) has long been a fundamental tool for managing federal estate tax liabilities. But with a sizable increase in the federal estate tax exclusion, some families are wondering if their ILIT is even relevant anymore.

An ILIT owns your life insurance policy for you, essentially removing it from your estate. ILITs were popular for their ability to shelter life insurance proceeds from estate taxes. They also give the grantor the ability to direct who benefits from the trust and how the proceeds are to be used.

But the Tax Cuts and Job Act doubled the estate tax exemption. In 2019, the exemption is $11.4 million per individual, indexed to inflation. That means many ILITs that were created to offset estate taxes are no longer needed.

Unwinding an irrevocable trust
As the name indicates, an ILIT is irrevocable, so once you place a life insurance policy inside it, you generally can’t take it back out. However, grantors do have options to shut down the trust or alter it in ways that still protect the interests of the beneficiaries.

Some strategies:

  • buy the policy back by funding the ILIT with the equivalent cash value
  • surrender the policy for cash value and distribute the cash to the beneficiaries
  • investigate a life settlement and distribute the value to the beneficiaries
  • stop funding the policy but use the cash value to extend the benefit until the cash value runs out
  • stop funding the policy, but maintain it at a reduced benefit amount
  • stop funding the policy and borrow the premium payments from the beneficiaries, assuming the beneficiaries wish to keep the policy.

The trustee must honor the terms of the trust, and certain trusts may be more restrictive in terms of their rescue options. The terms of the trust cannot change, but the involved parties (grantor, beneficiaries, trustee) do have options to eliminate an ILIT that is no longer needed.

Before you unwind

Remember that the current exemption rules expire after 2025. Without further legislation, the exemption will return to an inflation-adjusted $5 million in 2026.

Protecting your death benefits
Depending on your situation, an ILIT may still make sense. Consider how your life insurance strategy could impact your estate if:

  • you believe your estate will exceed the federal estate tax exclusion when you die
  • your estate will exceed any applicable state estate taxes (typically lower than federal exemptions)
  • your life insurance proceeds will tip your estate over the tax exclusion limit
  • creditors may make claims on your estate when you die.

The danger of waiting too long
You can gift an existing life insurance policy into an ILIT. However, if the insured dies within three years of making the gift, the policy will still be included in the estate for tax purposes.

Alternately, the ILIT can be funded with a new policy and the three-year “lookback” period would no longer apply. Of course, the costs of purchasing a new policy tend to increase as you age, which might make that strategy impractical.

Talk to an estate planner who will help you review your life insurance and estate plans and determine if changes are needed.

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