Owning a life insurance policy can provide peace of mind that your family’s financial well-being will be taken care of after you’re gone. It’s generally a good idea to set up an irrevocable life insurance trust (ILIT) to hold the policy. Doing so will keep the policy’s proceeds out of your taxable estate.

But what if you have an ILIT that you no longer need? Does its irrevocable nature mean you’re stuck with it forever? Not necessarily. Much depends on the terms of the trust and your state’s applicable law.

What’s an ILIT?

An ILIT shields life insurance proceeds from estate tax because the trust, rather than the insured, owns the policy. Note, however, that under the “three-year rule,” if you transfer an existing policy to an ILIT and then die within three years, the proceeds remain taxable. That’s why it’s preferable to have the ILIT purchase a new policy, if possible, rather than transferring an existing policy to the trust.

The key to removing the policy from your taxable estate is to relinquish all “incidents of ownership.” For example, that means you’re prohibited from retaining the right to do the following:

• Change beneficiaries,
• Assign, surrender or cancel the policy,
• Borrow against the policy’s cash value, or
• Pledge the policy as security for a loan.

However, the trustee may be granted the power to do these things.

How do you undo an ILIT?

Generally, there are two reasons you might want to undo an ILIT. First, you might not need life insurance anymore. Second, you might still need life insurance but your estate isn’t large enough to trigger estate tax, and you’d like to eliminate the restrictions and expense associated with the ILIT structure. Although your ability to undo an ILIT depends on the circumstances, potential options include:

Allowing the insurance to lapse. This may be a viable option if the ILIT holds a term life insurance policy that you no longer need (and no other assets). You simply stop making contributions to the trust to cover premium payments. Technically, the ILIT continues to exist, but once the policy lapses it owns no assets. It’s possible to allow a permanent life insurance policy to lapse, but other options may be preferable, especially if the policy has a significant cash value.

Swapping the policy for cash or other assets. Many ILITs permit the grantor to retrieve a policy from an ILIT by substituting cash or other assets of equivalent value. If allowed, you may then be able to gain access to a policy’s cash value by swapping it for illiquid assets of equivalent value.

Surrendering or selling the policy. If your ILIT holds a permanent insurance policy, the trust might surrender it, which will preserve its cash value but avoid the need to continue paying premiums. Alternatively, if you’re eligible, the trust could sell the policy in a life settlement transaction.

Distributing the trust assets. Some ILITs give the trustee the discretion to distribute trust funds (including the policy’s cash value, other trust assets or possibly the policy itself) to your beneficiaries, such as your spouse or children. Typically, these distributions are limited to funds needed for “health, education, maintenance and support.”

Going to court. If the ILIT’s terms don’t permit the trustee to unwind the trust, it may be possible to obtain a court order to terminate it. For example, state law may permit a court to modify or terminate an ILIT if unanticipated circumstances require changes to achieve the trust’s purposes or if the grantor and all beneficiaries consent.

These are some, but by no means all, of the strategies that may be available to unwind an ILIT.

Talk to your advisor

If you’ve recently reviewed your estate plan and decided that an ILIT no longer meets your needs, contact your advisor or lawyer to learn about pulling the life insurance policy out of the ILIT or even unwinding the ILIT entirely. Be sure to ask about the tax implications of taking such actions.

© 2024