Planning for a Rainy Day – Using a Life Insurance Trust To Care For Your Loved Ones and Provide Liquidity For An Estate


Many financial planners suggest people create a “rainy day” fund to handle unexpected cash needs that come up, like a car repair or an unexpected increase in a child’s after-school activity. But many people do not realize that having this type of liquid fund is an important part of estate planning, too.

As people plan for their estates, they often want to address many different concerns, such as caring for loved ones, keeping a family business or properties together for the next generation and planning for an estate tax bill. These diverse goals can be difficult to accomplish when there are significant assets – such as real estate holdings – and very little liquid cash. This is where some planning during life can provide an estate with a “rainy day” fund to handle these different needs. The Irrevocable Life Insurance Trust (“ILIT”) is a flexible tool for providing such a fund.


An ILIT combines two commonly used estate planning techniques: life insurance and an irrevocable trust. Life insurance is an excellent means of providing liquidity for an estate; however, if the decedent owned the insurance policy, its payout value is included in their taxable estate. Additionally, there may be reasons why beneficiaries should not immediately receive access to the insurance funds, such as if they are minors, have special needs or are known to have issues managing money. A trust, however, can be utilized to mitigate both situations.

In order to keep assets out of the decedent’s taxable estate, they should be placed in an irrevocable trust. Generally, this type of trust cannot be changed or controlled by the person who created it (the grantor) and requires an independent trustee.

Strategic / Practical

There are many practical considerations when creating an ILIT. These are a few of the issues people should keep in mind when considering this estate planning option:

Choose an independent trustee. An independent trustee for an ILIT is defined within the Internal Revenue Code (“IRC”) to mean someone who is not “related or subordinate” to the grantor. A related party is the grantor’s spouse, parent, child or sibling, and a subordinate party is an employee of a company owned by the grantor or a subordinate employee in a company where the grantor is an executive. The trustee should be someone outside of this group of people.

Consider who the beneficiaries are and what you want the trust to be able to do. The power of a trust is that it can care for loved ones without giving them all of the assets at once. Think about who you want to make a beneficiary of the trust, how you would like to care for them and when you want certain payouts to occur.  Additionally, consider giving the trustee the flexibility to work with the estate, such as having the discretion to buy assets from your estate or lend funds to the executor on an as-needed basis.   Bear in mind that the trust cannot mandate or require the trustee to purchase assets or lend money to the estate, as that creates an issue of control and could draw the trust into the taxable estate.

Married couples can have a joint ILIT. If spouses are engaging in joint estate planning, they may want to determine whether it is more advantageous to create a joint ILIT with a second-to-die life insurance policy or to establish individual ILITs. As part of an overall plan, it may make sense to create a joint spousal ILIT.  If separate ILITs are created at the same time, then each will have to be designed to avoid the reciprocal trust doctrine. The reciprocal trust doctrine arises from court cases where the Internal Revenue Service (“IRS”) scrutinized estate plans that removed assets from each spouse’s taxable estate. The plans had each spouse create a trust for the benefit of the other, leaving the spouses in the same economic position as if they had made themselves the beneficiary of the trust. The court permitted the IRS to unwind the trusts and bring them into the spouses’ respective taxable estates.

It is better to have the trustee purchase the life insurance policy.  As outlined above, the ownership of the life insurance policy matters when it comes to estate tax. After the ILIT is set up, the trustee should proceed with purchasing the life insurance policy. This keeps the value of the policy out of the grantor’s taxable estate. It is possible for the grantor to gift a policy they own to the ILIT, but there is the possibility it may be included in their taxable estate. The IRC requires a three-year look back from the date a policy is gifted to a trust.  If the grantor dies during this lookback period, then the policy is included in the grantor’s taxable estate.


Here is an example of how an ILIT can meet multiple goals and act as an estate’s “rainy day” fund.

A single father of two teenage children has assets worth $9 million. He owns two pieces of real estate, a residence worth $3.2 million and rental property (the family business) worth $4.8 million. He also has bank accounts totaling $1 million. He wants to make sure his children go to college and that both pieces of real estate are kept for his children to use and utilize for income until they are older.

If the father passed away in 2016, this $9 million estate would have owed about $1,933,840 in federal and New York State estate taxes. Since the liquid assets total only $1 million, the estate would need to sell one of the pieces of real estate, which is not the desired outcome.

However, an ILIT set up to care for the children with a $4 million insurance policy could change this story. Provided the ILIT grants the trustee the discretion to purchase property from the estate, it can act as the fund this estate needs. The insurance proceeds would not increase the decedent’s taxable estate. The trustee would be able to buy the residence, providing the estate the funds to pay the tax bill while still preserving the property for the children. The ILIT would still have funds to pay for both children to go to college. The cost of setting up and maintaining the ILIT (such as payment of annual premiums) should be significantly less than the benefits of the insurance proceeds. The benefits of the providing liquidity for the estate and the decedent’s family may outweigh the costs. ILITs can help accomplish multiple goals in estate planning and are an excellent way to plan for a rainy day.


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