If your estate is large enough that estate taxes are a concern, it’s important not to own your life insurance policy at the time of your death, even if it provides peace of mind during your lifetime. This is because the policy’s proceeds will be included in your taxable estate. One common estate strategy utilized to avoid this scenario is to set up an irrevocable life insurance trust (ILIT) to hold the policy.

However, there may come a time when an ILIT is no longer needed. It’s irrevocable nature may not mean you’re stuck with it forever. You might have the option of pulling a life insurance policy out of an ILIT or even unwinding the ILIT entirely depending on the ILIT’s terms and applicable state law.

How Does An ILIT Work?

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.” This means, for example, that you can’t retain the power to change beneficiaries; assign, surrender, or cancel the policy; borrow against the policy’s cash value; or pledge the policy as security for a loan (though the trustee may have the power to do these things).

What Are The Options For Undoing An ILIT?

Generally, there are two reasons you might want to undo an ILIT:

1. You no longer need life insurance, or
2. You 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 ILIT’s terms and applicable state law, 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, the ILIT owns no assets. It’s also 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 you have illiquid assets but need cash, you may be able to gain access to a policy’s cash value by swapping the policy 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.

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These are some, but by no means all, of the strategies that may be available to unwind an ILIT. Keep in mind that some of these solutions can have tax implications for you or your beneficiaries. Contact us to learn more about ILITs.