We often buy life insurance for simple reasons: to ensure that when we're gone our loved ones can cover final costs, pay off debts, and sustain themselves for a while. But the reality is more complicated, and there's a good chance Uncle Sam could claim a hefty portion of the life insurance proceeds through estate taxes. Depending on the estate size, the federal government could take up to 40% of a life insurance death benefit. Think about that for a moment: you've worked hard to create financial security for your family, only to have a huge chunk of it taken away. Fortunately, with a bit of planning, this doesn’t have to be the case.

The magic here isn’t some loophole — it's about understanding ownership. Estate tax only hits property you own at the time of your death. So, if you don’t technically own your life insurance policy, that hefty tax bill could disappear. This is where the concept of an Irrevocable Life Insurance Trust (ILIT) comes in.

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What is an ILIT?

An ILIT is a trust designed specifically to hold life insurance policies. If structured and funded correctly, an ILIT can ensure that the life insurance proceeds go to your loved ones without being subject to estate tax.

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Why Ownership Matters

Estate tax only applies to property you own when you pass away, meaning that if you don’t own your life insurance, the proceeds could be exempt. Let’s frame it this way: you can do everything right, diligently pay premiums, and set your family up for financial success after you're gone, but if you own the policy, it could still become part of your taxable estate. Ownership, in this case, is not just about control but how the tax code defines your financial footprint. If you set up an ILIT, the trust, not you, owns the policy. This way, the life insurance payout goes directly to the beneficiaries of the ILIT, and it avoids being included in your taxable estate. This small shift can make a world of difference.

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The ILIT Playbook

You’ll need an experienced attorney to draft the trust document. While this involves some costs, the potential savings in estate taxes could make it a worthwhile investment.

An ILIT owned life insurance policy is not included in the taxable estate of the insured. You can either transfer an existing policy to the ILIT (though there’s a three-year waiting period to avoid estate taxes) or have the ILIT buy a new policy. Any contributions you make to the ILIT, such as premium payments, count as gifts and may be subject to gift taxes. However, with proper structuring, you can use gift tax exclusions to minimize gift tax.

In simple terms it works like this: the ILIT owns the policy, you transfer money to the trust, and the trust pays the premiums. When you die, the life insurance payout goes into the trust and then to your designated beneficiaries, untouched by estate taxes. The ILIT allows you to build a vault around your life insurance, and that vault prevents the IRS from dipping into it when you're no longer around.

The catch? An ILIT is irrevocable — once you create it, you can’t change your mind. That permanence might feel restrictive, but it’s the price of keeping your family’s financial safety net intact.

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Gift Tax and Crummey Rights

Transfers to the ILIT are taxable gifts, but under current laws, you can avoid gift taxes if the transfer is within the annual gift tax exclusion ($18,000 per beneficiary in 2024). To qualify, beneficiaries must be given withdrawal rights, known as Crummey rights, which allow them a limited time to access the funds you’ve transferred to the trust. However, they typically do not exercise this right.

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Final Thoughts

When you break it down, setting up an ILIT isn’t just about minimizing taxes — it's about maximizing what you leave behind. By taking control of the process now, you're ensuring that the money intended for your loved ones goes exactly where you want it to, and not into the government's hands. This might sound like a detail buried in estate law, but it’s really a story about ownership and control. And in the long run, it’s these small, deliberate choices that safeguard your family’s financial future.

It’s important to work with professionals to navigate the complexities and ensure that your trust is structured correctly for your financial goals. If you would like to explore how an ILIT might fit into your financial plan, schedule a call with us today.

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