Exploring the Possibilities of Undoing an Irrevocable Life Insurance Trust

Life insurance is a crucial component of estate planning, offering an immediate source of wealth and liquidity to address your family's financial needs after your passing. To protect these proceeds from potential estate taxes and maximize the benefits for your loved ones, many individuals choose to transfer their policies into irrevocable life insurance trusts (ILITs).

However, if you find yourself with an ILIT that no longer serves its intended purpose, does the irrevocable nature of the trust mean you're permanently bound to it? Not necessarily. There are options available that may allow you to extract a life insurance policy from an ILIT or even dissolve the ILIT entirely.

The Advantages of an ILIT

An ILIT effectively shields life insurance proceeds from estate taxes because the trust, rather than the insured individual, owns the policy. It is important to note that under the "three-year rule," if an existing policy is transferred to an ILIT and the insured dies within three years of the transfer, the proceeds will still be subject to taxation. For this reason, it is generally preferable to have the ILIT purchase a new policy rather than transferring an existing one into the trust.

To remove a policy from your taxable estate, it is essential to relinquish all "incidents of ownership." This means that you cannot retain the ability to change beneficiaries, assign, surrender, or cancel the policy, borrow against its cash value, or pledge the policy as collateral for a loan. These actions, however, may still be performed by the trustee if necessary.

Reasons to Consider Undoing an ILIT

There are typically two primary reasons one might seek to undo an ILIT:

1. The life insurance policy is no longer necessary.

2. The policy is still needed, but the size of the estate no longer warrants the complexity and costs associated with maintaining the ILIT.

While the ability to unwind an ILIT depends on the specific circumstances, there are several potential strategies to consider:

- Allowing the Insurance Policy to Lapse: If the ILIT only holds a term life insurance policy that is no longer needed, you may simply stop making contributions to the trust for premium payments. Although the ILIT will technically continue to exist, it will no longer hold any assets once the policy lapses. While this approach can also be applied to permanent life insurance policies, other options may be more advantageous, especially if the policy has accumulated significant cash value.

- Swapping the Policy for Cash or Other Assets: Many ILITs allow the grantor to reclaim a policy by substituting it with cash or other assets of equivalent value. This may enable access to the policy’s cash value by exchanging it for less liquid assets.