How to Properly Fund an Irrevocable Life Insurance Trust

An Irrevocable Life Insurance Trust, commonly referred to as an ILIT, is a specialized legal arrangement designed to own a life insurance policy. Its primary purpose involves removing the death benefit proceeds from the grantor’s taxable estate, which can significantly reduce potential estate taxes upon death. An ILIT also serves to provide liquidity to an estate, ensuring funds are available to cover expenses such as taxes and administrative costs without forcing the sale of other assets. For an ILIT to effectively achieve these estate planning goals, it must be properly established and funded to ensure life insurance premiums are consistently paid.

Types of Assets for Funding

Several types of assets can fund an ILIT. Cash is often the most straightforward method, typically contributed directly to the trust’s dedicated bank account for immediate liquidity.

An existing life insurance policy can also be transferred to an ILIT. This involves changing the ownership of the policy from the individual to the trust. When transferring an existing policy, consider the “transfer-for-value” rule, which could make a portion of the death benefit taxable if not handled correctly. This rule generally applies when a policy is transferred for valuable consideration. Proper legal guidance is advisable to avoid unintended tax consequences.

Beyond cash and existing policies, income-producing assets like stocks, bonds, or real estate can be gifted to the trust. The income generated from these assets can then be used by the trustee to pay life insurance premiums. Using income-producing assets introduces complexities, including valuation requirements and ongoing management responsibilities for the trustee. A formal valuation may be necessary for non-cash assets to determine fair market value for gift tax purposes.

Mechanics of Initial Funding

When funding with cash, the grantor typically transfers the initial contribution to a dedicated bank account opened in the name of the ILIT. The trustee is responsible for establishing this account and ensuring funds are properly deposited and managed.

For an existing life insurance policy, the process requires formally assigning ownership to the ILIT. This is done by obtaining the change of ownership form from the life insurance company. The grantor completes and submits this form to the insurer, who records the ILIT as the new owner. It is important to ensure the insurer properly acknowledges and processes this change to validate the transfer.

If income-producing assets are used, legal steps are necessary to transfer title or ownership to the ILIT. For real estate, this involves executing and recording a new deed. For marketable securities, transfer forms must be completed, and securities re-registered in the trust’s name. Meticulous documentation of all transfers is essential to prove assets are legally owned by the trust.

Managing Ongoing Contributions

After initial funding, ongoing contributions ensure the ILIT has sufficient funds for recurring life insurance premiums. The grantor typically makes regular cash contributions to the trust for this purpose. These contributions are considered gifts to the trust beneficiaries.

A crucial aspect of ongoing contributions involves Crummey notices. These notices are sent by the trustee to beneficiaries each time a contribution is made. They inform beneficiaries of their temporary right to withdraw a portion of the gifted funds, typically for a period of 30 to 60 days. This withdrawal right transforms the gift into a “present interest” gift, necessary for the contribution to qualify for the annual gift tax exclusion.

The trustee sends these notices and documents their delivery. Beneficiaries almost always allow their withdrawal right to lapse, keeping funds within the trust. Once the Crummey withdrawal period expires, the trustee uses the funds to pay the life insurance policy premiums.

Tax Considerations for Funding

Funding an ILIT involves several tax considerations. Gifts made to an ILIT are generally subject to federal gift tax rules. Grantors can utilize the annual gift tax exclusion, which for 2025 is $19,000 per recipient, to make tax-free gifts. If gifts exceed the annual exclusion, the excess reduces the grantor’s lifetime gift tax exemption, which is $13.99 million per individual for 2025.

The generation-skipping transfer (GST) tax applies to transfers made to beneficiaries two or more generations younger than the grantor, such as grandchildren. Grantors can allocate their GST exemption, unified with the gift tax exemption, to gifts made to the ILIT to avoid this tax. Proper allocation of this exemption is important for trusts intended to benefit future generations.

Regarding income tax, the death benefit paid from a life insurance policy held within an ILIT is generally received by the trust income tax-free. If the ILIT holds income-producing assets, any income generated, such as dividends or interest, is subject to income tax within the trust. The taxation of trust income can be complex, often depending on whether income is distributed or retained. Consulting with qualified tax and legal professionals is advisable.