What is an irrevocable life insurance trust (ILIT)?
An irrevocable life trust or ILIT is an entity created to hold a life insurance policy. Its primary purpose is to minimize estate taxes by transferring ownership of the life insurance policy away from the insured. Putting the policy in an irrevocable trust generally precludes the value of the death benefit from being added to the taxable estate.
Estate planners may also use ILITs to ensure the death benefit is paid out according to the insured’s wishes. Let’s say you own a life insurance policy and your advisor team recommends putting that policy into an ILIT. In that scenario, you are the insured on the policy and also the grantor of the trust. You would assign someone else to be the trustee, or manager of the trust assets; you cannot be both trustee and grantor on the same trust.
As grantor, you would design the rules of the trust in partnership with your financial and legal advisors. Those rules specify how and when the assets are ultimately distributed to your beneficiaries. You could, for example, designate a minor child as the beneficiary of the trust. If you die while the beneficiary is still a minor, the death benefit could be held in the trust and then transferred when the beneficiary is of legal age. You could also specify payments for an adult beneficiary — which might be appropriate if that person has historically been irresponsible with cash windfalls. The trust could also handle any number of payouts to multiple family members or causes.
Once your attorney establishes the trust, you’d transfer an existing life insurance policy into it, or the trust would purchase a new policy. Know that transferring an existing policy — especially one with a large cash value — has its complexities. You would need the guidance of an experienced advisor to oversee the process. But assuming you navigate those issues, the trust would become the new owner and beneficiary of that policy.
Going forward, the trust would pay the policy premiums and, ultimately, receive the death benefit. When that happens, the trustee distributes the funds according to the rules of the trust. Once the trust has fulfilled its purpose, it can be terminated.
Incidentally, you cannot modify an irrevocable trust. The trustee can make some changes, but only with the approval of all trust beneficiaries.
Do life settlements work in ILITs?
Yes, a trustee can sell an ILIT-owned life insurance policy through a life settlement. The normal eligibility requirements for a life settlement would apply. That means the policyholder needs to be 65 or older and the policy must have a face value of at least $50,000. Most types of permanent life insurance can be sold, as can convertible term life policies.
Whether the policy is owned by an individual or held within an ILIT does not affect its value on the secondary market at all. Buyers may want to see a copy of the trust prior to making an offer — to understand any rules or restrictions in play. But beyond that, the sale of an ILIT-owned policy would follow the normal life settlement process.