An ILIT can protect life insurance proceeds from estate tax

Life insurance is often a cornerstone of estate planning, providing liquidity to cover estate taxes, debts or other obligations. However, life insurance proceeds generally will be included in your taxable estate if you own the policy outright. So if your estate is (or in the future might be) large enough that estate taxes are a concern, you’ll want to consider strategies for shielding insurance proceeds. An irrevocable life insurance trust (ILIT) is one option. It removes the policy from your estate, ensuring that the death benefit passes to your beneficiaries free of estate tax.

How it works

To establish an ILIT, you create an irrevocable trust, transfer ownership of an existing life insurance policy to it and designate beneficiaries. Alternatively, you can set up an ILIT as the owner of a new policy you purchase. In addition, the ILIT must be funded so that it’s able to pay the premiums on the policy.

The transfer of an existing policy to an ILIT is, however, considered a taxable gift. Further, subsequent transfers to the trust to fund premiums would also be treated as gifts. But the gifts can be sheltered from tax by your available gift and estate tax exemption. (You may even be able to add “Crummey” provisions to your ILIT that allow you to apply your gift tax annual exclusion to the transfers to the trust for funding premiums.) Gifts up to the annual exclusion amount — $19,000 for 2025 — are tax-free and thus don’t use up any of your lifetime exemption.

Because the trust is irrevocable, you can’t change its terms once established. For example, you can’t change the beneficiaries. But this “loss of control” is what keeps the proceeds outside your taxable estate. You can, however, name another family member or a knowledgeable professional as the trustee.

Typically, you’ll designate the ILIT as the primary beneficiary of the life insurance policy. On your death, the proceeds are deposited into the ILIT and held for distribution to the trust’s beneficiaries. In most cases, these will be your spouse, children, grandchildren or other family members.

Potential pitfalls

There are some pitfalls to watch for when transferring an insurance policy to an ILIT. For example, if you transfer an existing policy to the ILIT and die within three years of the transfer, the proceeds will be included in your taxable estate. But the three-year rule doesn’t apply if the ILIT purchased a new policy on your life.

Another pitfall is naming your surviving spouse as the sole beneficiary. It may merely delay estate tax liability until your spouse dies (assuming he or she outlives you).

Consider all your options

An ILIT isn’t a one-size-fits-all solution. It’s generally most beneficial for high-net-worth individuals who anticipate significant estate tax exposure.

The trust can provide heirs with tax-free liquidity precisely when it’s needed most, without forcing the sale of family assets or business interests to cover tax bills. But if estate tax liability isn’t a significant risk for you, the tax benefits of an ILIT may not outweigh the downsides of giving up control of the policy. We can help you determine whether an ILIT is appropriate for achieving your goals.

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