Life insurance is meant to protect your family. But if your estate is large enough to trigger federal estate taxes, the IRS may count the death benefit as part of your taxable estate. An irrevocable life insurance trust (ILIT) can stop that from happening.
The Problem: Life Insurance and Estate Taxes
Under IRC 2042, life insurance payouts are counted in your gross estate if you hold any "incidents of ownership" in the policy at death. This means the right to change who gets the money, borrow against it, or cancel it.
Say you own a $1 million policy. If your estate is near the federal cutoff ($13.99 million per person in 2025), that payout could push you over the line. Your family could pay estate taxes of 40% on the excess. For large estates, this can mean hundreds of thousands lost to taxes.
How an ILIT Solves This
An ILIT owns the policy instead of you. The trust is the owner and the payee. You hold no rights over the policy. When you pass away, the death benefit goes to the trust, not your estate.
The trustee then gives out the money to your loved ones based on the trust terms. No federal estate tax applies to that payout.
The key word is irrevocable. Once you set up an ILIT, you give up control. You cannot change the trust terms, take the policy back, or borrow against it. A trustee (not you) manages the policy and pays the premiums from trust funds.
The tax savings can be huge. A family that would owe estate taxes on a $2 million policy could save $800,000 or more with an ILIT.
The Three-Year Lookback Rule
If you move an existing policy into an ILIT, timing matters. Under IRC 2035, if you die within three years of the transfer, the payout gets pulled back into your taxable estate. The IRS treats it as if the move never took place.
To dodge this rule, many families have the ILIT buy a brand-new policy. Since the trust was always the owner, the three-year rule does not apply. This is often the cleanest path for families who plan ahead.
Crummey Notices and Annual Gifts
An ILIT needs cash to pay premiums. You give money to the trust each year. The trustee uses it to pay the insurance bill. To make these gifts count toward the yearly gift tax break ($19,000 per person in 2025), the trustee must send "Crummey notices" to those in the trust. These give them a short window to withdraw the gift.
This step is a must. Skipping it could turn each premium into a taxable gift. That would chip away at your lifetime gift tax limit.
Who Should Consider an ILIT?
An ILIT is not for everyone. It makes sense for families with estates near or above the federal estate tax cutoff. It also helps if you have a large policy and want every dollar to reach your family.
Families with smaller estates may not need one. Arizona has no state estate tax. The federal line is the only concern. A money advisor who knows estate tax planning can help you weigh the pros and cons.
How an ILIT Fits With Other Planning Tools
An ILIT works well with other estate planning tools. For very large estates, it can pair with GRATs, GST planning, and dynasty trusts to cut taxes across many family lines.
If you wonder whether an ILIT makes sense, reach out to start the talk. The sooner you plan, the more choices you have.