This article argues why an irrevocable Life Insurance Trust may be the right choice. 

We have carried a number of articles recently about the value and utility of trust structures, and this article continues the trend. It comes from Trevor Hamilton, principal and senior life insurance advisor at US-based Bessemer Trust, the multi-family office that will be familiar to many readers. The editors of this news service are pleased to share these views. The usual disclaimers apply to guest contributors' articles. Jump into the debate! Email tom.burroughes@wealthbriefing.com

Over the next decade, $16 trillion is projected to be passed down from older Americans to Millennial and Gen X heirs, and families are facing important discussions on how to preserve their wealth for future generations. Though wealth transfer can be complicated, there are several strategies for families to consider that can help manage the process to meet their wealth goals.

Of these strategies, irrevocable life insurance trusts, or ILITs, have historically been a favorable vehicle for tax-efficient wealth transfer and meeting a variety of estate planning wishes. When held in an ILIT, ownership of a life insurance policy transfers from the insured individual to the trust, enabling the death benefit to move out of the estate and, eventually, to beneficiaries, tax free.

While ILITs host a variety of benefits, the scheduled reduction of the lifetime gift and estate tax exemption in 2026 opens new opportunities. With no policy changes anticipated for the coming years, the currently high exemption – $12.92 million for individuals or $25.84 million for couples in 2023 – will revert to $6.4 million for individuals and $12.8 million for couples in 2026 (indexed annually for inflation). Now is an opportune time for advisors to assess the following benefits of ILITs with clients to determine if they are an appropriate element for their wealth transfer plans. 

Leaving more for loved ones
Setting up an ILIT can offer an individual the peace of mind in knowing that their wealth will be transferred to their heirs in the amount they had envisioned. This is because the death benefit does not count as part of one’s estate when a life insurance policy is owned by an ILIT, putting the individual in a position to leave material assets to heirs without creating a tax event for the estate. If paid by the individual, annual premiums are considered taxable gifts, yet taxes will be small relative to taxes if the policy were left as part of the estate. These potential taxes could possibly be mitigated by using one’s annual gift tax exclusion or through using another means of funding the premiums, such as a split-dollar agreement or private loans.

In one example, a mother of two, has a goal of leaving $20 million in liquid assets to her children to help them support their own families. She contemplates purchasing a permanent life insurance policy with a $20 million death benefit. However, with the size of her overall estate and the uncertainties over the estate tax exemption, the benefit could be exposed to 40 per cent estate taxes, leaving only $12 million for her children. Instead, she creates an ILIT naming her children as beneficiaries and a trusted person as trustee. In taking this route, her children will receive the full $20 million she envisioned, for the price of $30,000 in annual premiums – which is covered under her annual gift tax exclusion – and modest setup and maintenance fees for the trust.

Shielding wealth from threats
When ILITs are not in place, a death benefit can be subject to claims in situations where the beneficiary is divorced, or from lawsuits or creditors if a beneficiary is facing financial or legal trouble. In other instances, parents or grandparents might be concerned about the readiness of younger family members to handle a large influx of wealth. Similar to trusts, ILITs can protect the death benefit from these types of external risks, allowing appointed trustees to exercise discretion on how and when to allocate the assets to family members.

For wealthy individuals with grown children who are financially stable and are likely to pass down any inheritance to their own children or grandchildren, facing a death benefit could pose estate tax issues for them. In these instances, individuals should consider creating a dynasty trust and applying the generation-skipping tax exemption to enable the benefit to go directly to their grandchildren or great-grandchildren at the right time.

Leveraging liquidity for other expenses
As an estate is being settled, the death benefit may provide a substantial source of liquidity for a family since the policy is held outside of the estate. The death benefit, for example, could be used to pay an estate tax bill to prevent a forced sale of illiquid assets such as a business, or real estate or private equity holdings. While the ILIT cannot directly pay an estate tax bill, the trust could purchase assets from the estate, yielding the liquidity required to pay the tax.

This can be an effective strategy for those seeking to preserve their family business. Case in point: the owner of a $100 million manufacturing business hopes that his company will span his grandchildren and great grandchildren. To avoid his family potentially having to sell the business just to pay the 40 per cent estate tax – which totals $40 million – he creates an ILIT that has an insurance policy with a $40 million death benefit. Following his death, the ILIT uses the death benefit to purchase a $40 million share of the company from the estate, providing the liquidity it needs to pay the tax. According to the owner’s wishes, the trustee of the ILIT can then hold the company shares for the benefit of the descendants.

Weighing the risks and rewards 
While the benefits of ILITs are clear, there are important considerations that advisors should assess with clients to determine whether an ILIT is suited for their needs. As with any irrevocable trust, ILITs can be difficult to change or amend once instituted. Additionally, an individual gives up control of their life insurance policy, forgoing the ability to change death benefit beneficiaries or to cancel the policy or borrow against it. The individual also won’t be able to access the accrued cash value during their lifetime as they would be able to with personally-owned life insurance.

Individuals should carefully consider the terms of their ILIT, and monitor performance over the years, as changing economic conditions may affect a policy’s crediting rates, cash value and market performance. The unpredictability of the insured’s lifespan also needs to be considered. The policy’s internal rate of return (IRR), which is based on the amount paid in premiums versus the death benefit, should begin by exceeding the returns one might realize through market investments. However, if the insured lives to an advanced age, the returns may ultimately become lower than desired since the IRR declines with each year the policy is in place.

Strategies today to achieve peace of mind tomorrow 
Despite these considerations, ILITs remain a powerful solution for individuals and families seeking tax-efficient vehicles to transfer wealth and offer a host of valuable estate planning benefits. As more families prepare to transfer wealth, and with the federal lifetime gift and tax exemption currently scheduled to decline in 2026, now is a worthwhile time for wealth holders to revisit their estate plans. Experienced insurance and estate planning advisors can help clients explore the options to determine whether an ILIT is well-suited to advance their wealth goals and needs.  

Disclaimer

This material is for your general information. It does not take into account the particular investment objectives, financial situation, or needs of individual clients. This material is based upon information obtained from various sources that Bessemer Trust believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. The views expressed herein do not constitute legal or tax advice; are current only as of the date indicated; and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in economic growth, corporate profitability, geopolitical conditions, and inflation. Bessemer Trust or its clients may have investments in the securities discussed herein, and this material does not constitute an investment recommendation by Bessemer Trust or an offering of such securities, and our view of these holdings may change at any time based on stock price movements, new research conclusions, or changes in risk preference.