Irrevocable Life Insurance Trust (ILITs) and Intentionally Defective Grantor Trusts (IDGTs) are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• Two Powerful Estate Tax Strategies: ILITs and IDGTs both save estate tax, but they’re used in different circumstances.
• ILITs are Extremely Tax Efficient: ILITs are highly tax efficient. The trust shelters the life insurance proceeds from estate tax, while the life insurance wrapper shelters the investment returns inside the policy from income tax.
• IDGTs are Tax-Efficient, Flexible Trust Structures: IDGTs are highly estate-tax efficient and make a lot of sense for people who are interested in transferring wealth to future generations and have not used their entire lifetime gift tax exemptions. A grantor can loan to, sell to, and borrow from an IDGT.

What is an ILIT?

An ILIT is a type of irrevocable trust that is designed to hold insurance. A person (the “grantor”) creates an ILIT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. Typically, the grantor funds the trust with cash, which the trust uses to acquire one or more life insurance policies, often on the grantor’s life. Once the life insurance policy is in the trust, it is outside of the grantor’s estate, and the proceeds will not be subject to gift tax, estate tax, or generation-skipping transfer tax. Because life insurance policies generally are not subject to income tax, ILITs are able to generate both income-tax savings (via the insurance policy) and estate-tax savings (via the trust). It’s possible for ILITs to own assets aside from life insurance, though generally they stick to holding life insurance policies plus a small amount of liquidity.

ILITs can hold any type of life insurance policy, from indexed universal life insurance (IUL) to term life insurance. But a specific type of variable universal life insurance policy, known as Private Placement Life Insurance (PPLI), works particularly well with ILITs and has become quite popular with high-net-worth individuals who are looking to transfer as much post-tax wealth to their family members as possible. Even after accounting for the fees that life insurance companies charge, an ILIT funded with PPLI will generally outperform other estate-tax strategies. (You can learn more about ILITs here.)

ILIT Example

Imagine that Ronald is a 40-year-old New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Ronald sets up an ILIT and then contributes $6 million to fund premiums on a PPLI policy, he will use up $6 million of his lifetime gift tax exemption, but the investments in the life insurance policy will be able to grow outside of his taxable estate. Even after fees, the policy will generate more than 8% annual post-tax returns. Meanwhile, the insurance charges will pay for a generous death benefit. If Ronald dies in Year 25, his beneficiaries will receive roughly $59.9 million of cash proceeds from the ILIT, and the total tax savings for his heirs will be about $39.9 million relative to if Ronald had done nothing.

Benefits of ILITs

1. Estate Tax Savings: The primary advantage of an ILIT is that it can shelter the proceeds of life insurance policies from estate tax upon the grantor’s death. Since the federal estate rate is 40% and in some states the effective estate tax rates (federal + state) are as high as 52%, this is an important benefit. When PPLI and ILITs are used in conjunction, the combined tax savings can be quite significant.
2. Asset Protection: An ILIT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, ILITs can help shield inherited assets from a divorcing spouse.
3. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to an ILIT when the trust is first funded. As a result, the ILIT is a popular form of dynasty trust.

Drawbacks of ILITs

1. Cash Funding: ILITs are typically funded with cash or cash equivalents so that the ILIT can pay large upfront insurance premiums. If an ILIT is funded with an appreciated asset, that asset will likely need to be sold in order to pay the insurance premiums.
2. Irrevocability: When a grantor makes a gift to an ILIT, the gift is irrevocable.
3. Less Liquid: IDGTs are highly liquid, because the grantor can easily borrow from them. It’s possible for the grantor of an ILIT to borrow from the ILIT as well, but it’s not so simple. The grantor can’t borrow directly against the policy without causing estate-tax problems. The grantor can borrow from the trust itself (as opposed to the policy), but that requires the trust to have assets (perhaps borrowed from the policy) that it can lend to the grantor.
4. No Direct Control: Typically the grantor does not act as trustee of the ILIT, though he or she can remove and replace the trustee at any time.

What is an IDGT?

An IDGT is a type of irrevocable trust that is optimized for estate-tax efficiency. A person (the “grantor”) creates an IDGT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. Because an IDGT is a “grantor trust,” the grantor has the option to pay the trust’s taxes without that being considered a gift, which is a way to transfer additional wealth to the trust. This makes IDGTs even more estate-tax efficient than they would otherwise be. (You can learn more about IDGTs here.)

IDGT Example

Imagine that Teresa is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Teresa sets up an IDGT for the benefit of her daughter and then contributes a $6 million asset to it, she will use up $6 million of her lifetime gift tax exemption, but the asset will be able to grow outside of her taxable estate. Teresa will also be able to pay the trust’s income taxes, allowing the trust to generate 9% annual post-tax returns and shifting more wealth out of Teresa’s taxable estate. After 25 years, the IDGT’s assets will be worth about $51.7 million! And if Teresa dies in Year 25, she will have saved her daughter about $20.4 million of tax that she would have otherwise owed.

Benefits of IDGTs

1. Estate Tax Savings: The primary advantage of an IDGT is its ability to use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes. The grantor can pay the income tax on the trust’s income, effectively shifting even more wealth into the trust and out of the grantor’s estate. Finally, the grantor can lend to the trust free of any tax consequences — loans are another powerful tool that taxpayers use to shift wealth out of their estates.
2. Asset Protection: An IDGT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, IDGTs can help shield inherited assets from a divorcing spouse.
3. Potential Income-Tax Savings: Although IDGTs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. That’s because an IDGT can make distributions to other taxpayers, who may be in lower tax brackets. The distribution itself will have no tax consequences, but when those taxpayers later sell the asset, they’ll pay less tax than the grantor would have paid, due to that lower tax bracket. IDGTs can also be transformed into “non-grantor trusts,” which can avoid state income tax.
4. Relative Liquidity: Compared to many other tax strategies, IDGTs have little impact on a grantor’s liquidity. Though the grantor will have transferred some portion of his or her assets to the trust, the grantor can borrow from the IDGT without any tax consequences. Moreover, if the grantor’s spouse is a beneficiary, he or she can receive distributions from the IDGT if necessary.
5. Ideal for Illiquid Assets: Unlike GRATs, IDGTs work well whether funded with liquid or illiquid assets.
6. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a IDGT when the trust is first funded. As a result, the IDGT is a popular form of dynasty trust.

Drawbacks of IDGTs

1. No State Income Tax Savings: IDGTs don’t save state income tax unless they’re converted to non-grantor trusts.
2. Irrevocability: When a grantor makes a gift to an IDGT, the gift is irrevocable (though the grantor can swap assets in and out of the trust at any time, as long as the swapped assets are exchanged for other assets with equal value).
3. No Direct Control: Typically the grantor does not act as trustee of the IDGT, though he or she can remove and replace the trustee at any time, lend money to or borrow money from the trust, get reimbursed by the trust for the trust’s tax liabilities (if the grantor doesn’t want to pay), and swap assets with the trust.

Should You Set Up an ILIT or an IDGT?

ILITs and IDGTs are similar strategies that save estate tax. Both are highly estate-tax efficient, and gifts to either ILITs or IDGTs will generally be GST exempt, which means that ILITs can make distributions to grandchildren or great-grandchildren without the distributions triggering any GST tax.

But IDGTs and ILITs are not identical.

For donors who are under 65 years old, in a position to gift $3 million or more to an irrevocable trust, and focused on maximizing what they pass on to their heirs, ILITs are a logical choice. Combining an ILIT with a PPLI policy will generally yield the highest post-tax return of any estate-tax strategy.

But for donors who don’t want to purchase a large insurance policy, or who want to maximize their access to trust liquidity, IDGTs (or some other type of irrevocable trust) may be a better choice since IDGTs are more liquid than ILITs. IDGTs are also better vehicles for receiving appreciated or illiquid assets, since they don’t need to generate cash in order to pay insurance premiums.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than an IDGT or an ILIT, depending on circumstances. Those strategies are also worth exploring. Moreover, IDGTs and ILITs are not mutually exclusive; many people set up both.

Conclusion

IDGTs and ILITs are both powerful tax strategies. ILITs make sense for people who are looking to make large gifts and want to maximize their heirs’ tax savings. IDGTs make sense for people who are looking for an estate-tax efficient tax strategy but don’t want the trust to purchase life insurance.

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