Using ILITs to Reduce Federal and Massachusetts Estate Taxes
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With the federal estate tax exemption set to drop in 2026, many families who were previously unaffected by estate taxes may soon face large bills. Irrevocable Life Insurance Trusts (ILITs) can help mitigate that risk.
Irrevocable life insurance trust (ILIT) & the 2026 Sunset
When planning for the future, it's important to understand the potential tax implications of life insurance benefits. While these benefits can often be received tax-free, there are certain conditions that can trigger estate taxes. This would ultimately reduce the inheritance left to beneficiaries. One effective strategy to avoid such taxes is through the use of an Irrevocable Life Insurance Trust (ILIT), which can offer significant advantages in protecting the value of the policy.
Understanding Estate Taxes
Estate taxes are taxes paid on the value of a person's assets when they pass away, applied to anything over a specific exemption amount. As of 2025, the federal estate tax exemption is $13.99 million per individual ($27.98 million for married couples). However, key provisions from the Tax Cuts and Jobs Act (TCJA) of 2017 are set to expire on December 31, 2025. After that, the exemption is expected to decrease to $7 million per individual ($14 million per married couple). As these exemptions decrease, more estates will be subject to estate taxes than before.
Many states impose their own estate taxes, and the exemptions vary depending on where you live. For example, in Massachusetts, if your estate is valued over $2 million and is left to a non-spouse beneficiary (such as children, a life partner, nieces, or nephews), the state will charge an estate tax. The tax rate ranges from 7.2% to 16% and applies only to the value of your estate that exceeds $2 million.
Life insurance can potentially reduce the amount passed on to your beneficiaries. One way to minimize this impact is by establishing an Irrevocable Life Insurance Trust (ILIT). This strategy helps families lower their estate tax liability by keeping life insurance proceeds outside of the insured’s taxable estate.
Understanding an Irrevocable Life Insurance Trust (ILIT)
An Irrevocable Life Insurance Trust (ILIT) is a specialized trust that holds life insurance policies. Once the trust is created and funded, the person who establishes the trust (the grantor) loses control over the assets in it. The trust becomes the owner of the life insurance policy and its beneficiary, which ensures the death benefit is not included in the grantor’s taxable estate.
Let’s walk through a hypothetical example of how an Irrevocable Life Insurance Trust (ILIT) would work in 2025 on the state and federal levels.
State Example
I'll use Massachusetts as an example since it's our home state. As mentioned earlier, estate taxes only apply to the portion of an estate that exceeds $2 million for Massachusetts residents.
For example:
An individual passes away with an estate valued at $3 million, which includes $1.9 million in real estate and investments, along with a $1.1 million life insurance policy.
If this individual did not have the life insurance policy, no estate tax would be owed, as the total estate value would be below the $2 million threshold and therefore not subject to estate tax.
However, because they owned the policy and did not have an ILIT, the total estate value remains at $3 million. This surpasses the $2 million estate tax exemption, resulting in an estate tax liability of approximately $83,000.
If the individual had set up an ILIT, with the trust as both the owner and beneficiary of the life insurance policy, the death benefit would be excluded from the estate. This would allow the beneficiary or beneficiaries to receive the full $1.1 million tax-free, resulting in savings of approximately $83K in estate taxes.
Federal Example:
Similar to state estate taxes, federal estate taxes operate under the same basic principles, though they feature higher exemption thresholds and tax rates. The federal estate tax can reach a maximum rate of 40%.
An individual (not married) passes away with an estate valued at $13.5 million and a $1.5 million life insurance policy.
If this individual did not have the life insurance policy, no estate tax would be owed, as the total estate value would be below the $13.99 million threshold and therefore not subject to estate tax.
However, because they owned the policy and did not have an ILIT, the total estate value increases to $15 million. This exceeds the estate tax exemption of $13.99 million per person, resulting in an estate tax liability of around $350,000.
By establishing an ILIT and making the trust both the owner and beneficiary of the life insurance policy, the death benefit would be excluded from the estate. As a result, the beneficiary or beneficiaries would receive the full $1.5 million tax-free, saving approximately $350,000 in taxes.
As mentioned earlier, the federal estate tax exemption is expected to decrease to $7 million per individual in 2026, which will lead to more families being subject to estate taxes. If you live in a state with an estate tax, your beneficiaries could be impacted on both the state and federal levels. This makes the benefits of an ILIT (outlined below) even more significant and impactful.
Collaborating with professionals to determine if ILIT is a good fit
Benefits of an ILIT
Estate Tax Reduction: By removing life insurance from the taxable estate, an ILIT can lower the overall estate tax liability.
Control Over Beneficiary Distribution: An ILIT allows the grantor to specify how the insurance proceeds are to be distributed among beneficiaries, which can help manage financial responsibilities and protect beneficiaries from mismanaging funds.
Protection from Creditors: Assets held in an ILIT are generally protected from creditors, ensuring that the life insurance proceeds are preserved for the intended beneficiaries.
Providing Liquidity: Estate taxes are often due within a short time frame after death. An ILIT can provide liquidity to cover these taxes without forcing heirs to sell other assets.
Gifting Strategy: Contributions made to fund the ILIT can be considered gifts to beneficiaries. This can help in reducing the size of the taxable estate over time.
How to Set Up an ILIT
Setting up an Irrevocable Life Insurance Trust (ILIT) involves several key steps:
Consult an Estate Planning Attorney: Start by discussing your goals with an estate planning attorney who specializes in trusts. They can guide you through the process and help ensure compliance with legal requirements.
Draft the ILIT Agreement: The attorney will create a trust document that outlines the terms of the ILIT, including the trustee's powers, beneficiary designations, and distribution instructions.
Choose a Trustee: Select a trustee who will manage the trust. This can be a family member, a trusted friend, or a professional fiduciary.
Fund the ILIT: After the trust is established, you need to fund it. This typically involves transferring ownership of an existing life insurance policy to the trust or purchasing a new policy in the name of the trust.
Pay Premiums: The trustee will be responsible for paying the insurance premiums. You may need to provide funds to the trustee for this purpose, often through gifts.
Complete IRS Form 709: If you make gifts to the trust, you may need to file IRS Form 709 (Gift Tax Return) to report the gifts, especially if they exceed the annual exclusion amount.
Review Regularly: Regularly review the trust and its terms with your attorney to ensure it continues to meet your financial goals and adapts to any changes in laws or personal circumstances.
By following these steps and seeking professional guidance, you can effectively set up an ILIT that helps protect your wealth and provides for your beneficiaries.
Strategic Considerations
While ILITs offer several benefits, they are not without limitations.
First, as the name indicates, ILITs are irrevocable. This means you can’t easily modify them once set up. However, modern trust features allow for flexibility, ensuring the trust can adapt to the evolving needs of the grantors and beneficiaries over time.
To prevent the life insurance policy from being included in your estate, it’s essential that you don’t retain ownership or control over it. This is where appointing an independent trustee comes into play. Fortunately, the administrative duties of an ILIT are manageable, making it straightforward to find a capable trustee.
Additionally, to cover ongoing insurance premiums, you will need to make periodic gifts to the ILIT. While this involves some paperwork to maintain tax efficiency, the process is typically straightforward.
Conclusion
With upcoming changes to estate tax laws after 2026, an Irrevocable Life Insurance Trust (ILIT) can be an important tool for those looking to protect their wealth. By keeping life insurance proceeds out of the taxable estate, ILITs can help offset the effects of a reduced estate tax exemption, provide funds for tax obligations, and create a structured way for beneficiaries to receive their inheritances. Working with an estate planning professional can help individuals navigate these changes and set up an ILIT that aligns with their long-term financial goals.
If you’d like an opinion on whether this strategy is right for you, we encourage you to reach out to our office.