05 Feb How ILITs Help High Net Worth Families

“But I thought life insurance wasn’t taxable?”

I was meeting with Saul, a wealthy real estate investor, about his estate planning.  Saul owns properties in multiple states, has multiple other assets, and he was meeting with me to talk about estate planning for his family. 

One of the biggest challenges he faces is his net worth (in excess of $40 million) is well over the current estate tax threshold ($13.99 million per individual in the U.S. but set to sunset at the end of 2025 to approximately $7 million, adjusted for inflation).

He had multiple life insurance policies, and we were discussing the impact of those on his estate tax.  That’s when he asked, “But I thought life insurance wasn’t taxable?”

It’s a common misconception I hear.  The root of the issue is to realize there are multiple types of taxation.  Here we need to distinguish between income taxation and death taxation.  While it’s true that life insurance is not subject to income tax to the beneficiaries, life insurance is subject to estate tax.  That means the death benefit on Saul’s life insurance policies would be added to his estate for estate tax purposes upon his death. This would lead to his family having to pay a hefty tax bill. 

What can Saul do here?  One potential remedy is an irrevocable life insurance trust, or “ILIT”.

In this article, I’ll explain what an ILIT is, how it works, and why it’s a must-have for high-net-worth individuals. An ILIT could be the missing piece in your estate planning puzzle.

What Is an Irrevocable Life Insurance Trust (ILIT)?

An ILIT is a specialized trust designed to own and manage a life insurance policy. Unlike a revocable living trust, which you can alter or dissolve during your lifetime, an ILIT is irrevocable. Once established, you, the grantor, cannot change its terms or reclaim the assets placed in the trust. While this may sound restrictive, the irrevocable nature of the trust is precisely what makes it so powerful for estate planning purposes.

Here’s how it works: You create the ILIT and transfer ownership of a life insurance policy (or purchase a new policy) into the trust. The trust becomes the policy’s owner and beneficiary. Upon your death, the death benefit is paid to the trust, which then distributes the proceeds to your designated beneficiaries according to the terms you’ve established.  An ILIT can help you mitigate estate taxes and achieve several other critical objectives:

1. Remove the Life Insurance Proceeds from Your Taxable Estate

One of the primary benefits of an ILIT is that it removes the life insurance proceeds from your taxable estate. If you own a life insurance policy at the time of your death, the death benefit is included in your estate for tax purposes. This could push your estate’s value over the exemption threshold, triggering a hefty tax bill.

By transferring the policy to an ILIT, you effectively remove it from your estate. The death benefit is paid to the trust, not to your estate, so it’s not subject to estate taxes. This can save your heirs hundreds of thousands—or even millions—of dollars in taxes.

2. Provide Liquidity to Pay Estate Taxes and Other Expenses

Sizeable estates often consist of illiquid assets, such as real estate, business interests, and investments. When estate taxes are due, your heirs may be forced to sell these assets at unfavorable prices to cover the tax bill. An ILIT can provide the liquidity needed to pay estate taxes, administrative expenses, and other costs without disrupting your estate’s assets.

For example, let’s say your estate includes a successful family business worth $20 million. If your heirs are forced to sell the business to pay estate taxes, they could lose control of a valuable asset—and a significant source of income. With an ILIT, the life insurance proceeds can cover the tax bill, allowing your heirs to retain ownership of the business.

3. Protect the Death Benefit from Creditors and Lawsuits

Assets held in an ILIT are generally protected from creditors and lawsuits. If you own a life insurance policy outright, the death benefit could be vulnerable to claims from creditors or legal judgments. By placing the policy in an ILIT, you shield the proceeds from potential threats, ensuring that your beneficiaries receive the full benefit.

4. Control How the Proceeds Are Distributed

An ILIT allows you to specify how and when the life insurance proceeds are distributed to your beneficiaries. For example, you might stipulate that the funds be used to pay for your grandchildren’s education, provide ongoing income for your spouse, or support a charitable cause. This level of control ensures that your wealth is used in accordance with your wishes.

5. Maximize the Value of Your Estate

By reducing estate taxes and providing liquidity, an ILIT can significantly increase the amount of wealth you pass on to your heirs. For example, if you have a $10 million life insurance policy, the full amount can go to your beneficiaries—not a reduced sum after taxes. This can make a dramatic difference in the financial security of your loved ones.

Is an ILIT Right for You?

If your estate is over the federal threshold, an ILIT could be a game-changer for your estate plan. It offers tax savings, asset protection, and control over your legacy. However, an ILIT is not a one-size-fits-all solution. It requires careful planning and ongoing administration to ensure compliance with tax laws and achieve your objectives.

Take the Next Step

Don’t leave your legacy to chance. If you’re ready to explore how an ILIT can benefit your family, talk to us: [https://lgarzalaw.com/schedule-online/]