Life Insurance Trust (ILIT): What It Is and When You Need One

Life Insurance Trust (ILIT): What It Is and When You Need One

By Elizabeth Kusmider, CFP®

Most people with life insurance own their policies personally. That works fine for straightforward income replacement situations. But for business owners and high-income individuals with estate planning goals, personal ownership of a large life insurance policy can create a tax problem that defeats part of the purpose of having the coverage.

An irrevocable life insurance trust (commonly called an ILIT) solves that problem. I am Elizabeth Kusmider, CFP® and independent life insurance broker. I work with estate attorneys and wealth managers to incorporate ILITs into complex planning strategies. Here is what they are, how they work, and when they are worth the effort.  

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The Core Problem an ILIT Solves

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Under federal estate tax law, life insurance proceeds are included in your taxable estate if you own the policy at the time of your death. For estates subject to federal estate tax (currently $15 million per individual, effectively $30 million for a married couple), that inclusion can result in a substantial portion of the death benefit going to the IRS rather than your heirs.

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Illinois compounds this with a state estate tax that applies at much lower thresholds, around $4 million. For Illinois business owners whose estates include a closely held company, real estate, and a large life insurance policy, all owned personally, the combined federal and state estate tax exposure can be significant.

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An ILIT removes the life insurance policy from your taxable estate. Because the trust owns the policy rather than you, the death benefit is not included in your estate when you die. The full proceeds go to the trust's beneficiaries without being reduced by estate tax.

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How an ILIT Works

Structure

An ILIT is an irrevocable trust, meaning it cannot be changed or revoked after it is created. You transfer ownership of an existing policy into the trust, or the trust purchases a new policy directly. The trust is the owner and the beneficiary of the policy.

You are the insured, but you are not the owner. That distinction is what keeps the death benefit outside your taxable estate.

Note that this transfer needs to take effect more then 3-years prior to your death. If you transfer policy ownership and pass away within 3 years, the clawback rule will include the policy in the total estate value. This is important to note and if the insured is insurable, it could be a better plan to get a new policy to put in force directly into the trust. This would avoid clawback issues.

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Funding the Premiums

Because you no longer own the policy, you cannot pay the premiums directly. Instead, you make annual gifts to the trust, and the trustee uses those gifts to pay the premiums. To ensure the gifts qualify for the annual gift tax exclusion (currently $19,000 per beneficiary per year for 2026), the trust document must include what are called Crummey provisions. These are notices to beneficiaries giving them a brief window to technically withdraw the gift before it is used for the premium. We do not want the gift beneficiary to do this seeing as it would leave the insurance policy unfunded.P

This is an administrative requirement but not a complex one. Your estate attorney handles the Crummey notice process as part of the trust administration.

Distribution at Death

When you die, the death benefit is paid to the ILIT rather than to anyone individually. The trustee then distributes the proceeds according to the trust document, which can be written to pay estate taxes directly, provide income to a surviving spouse, or distribute outright to children or other beneficiaries. The trust terms give you control over how the money is used, even though you no longer control the policy.

Who Needs an ILIT

An ILIT is most valuable in specific situations:

• Estates that are or may be subject to federal or state estate tax
• Business owners whose estates include a closely held company and a large life insurance policy, where the combined estate value exceeds the applicable exemption threshold
• High-income earners who are accumulating assets rapidly and anticipate an eventual estate tax exposure
• Individuals with existing large permanent life insurance policies who want to remove the death benefit from their estate without surrendering the coverage
• Estate plans where providing liquidity for estate tax payment without forcing a business sale is a priority

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For most people with straightforward estates well below the exemption thresholds, an ILIT is unnecessary. For the client base I typically work with (business owners and high-income earners), it is frequently worth discussing.

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The Three-Year Rule, The Clawback

One important timing consideration: if you transfer an existing policy that you personally own into an ILIT, the IRS requires a three-year waiting period before the death benefit is fully excluded from your estate. If you die within three years of the transfer, the proceeds are still included.

This is why I generally recommend having the ILIT purchase a new policy directly, rather than transferring an existing one. The trust buys the policy from inception, which avoids the three-year rule entirely.
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Coordinating the ILIT with the Rest of Your Plan

An ILIT does not operate in isolation. It needs to be coordinated with your will, your other trust documents, your buy-sell agreement if you have one, and your overall estate plan. I work with the estate attorney handling your plan to make sure the insurance strategy and the legal structure are aligned.

Block type

If you have a large life insurance policy and your estate may be subject to estate tax, understanding whether an ILIT makes sense for your situation is a conversation worth having sooner rather than later. The options are more flexible before the policy is already in place.

Elizabeth works closely with wealth managers and estate attorneys to bring insurance planning into broader client conversations. We are here to help make that process simple, not stressful. To schedule a planning session or discuss a client situation, reach out to Elizabeth Kusmider, CFP® at info@kusmiderconsulting.com.

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