Irrevocable Life Insurance Trusts (ILITs): A practical guide
An Irrevocable Life Insurance Trust (ILIT) is a common estate planning tool that can remove life insurance proceeds from an estate, provide immediate liquidity for heirs (to pay taxes, debts, or business obligations), and offer an extra layer of creditor protection. In my 15+ years working with families and business owners on estate planning, I’ve seen well-structured ILITs prevent forced sales of businesses, preserve ranch or farm operations, and make tax bills manageable for heirs.
Why people use an ILIT
- Estate-tax mitigation: When structured correctly, the life insurance death benefit payable to an ILIT is not included in the grantor’s taxable estate. That can reduce or avoid estate taxes that otherwise would be owed on a large estate [IRS — Estate Tax].
- Liquidity at death: Proceeds in an ILIT provide cash to pay estate settlement costs, estate taxes, mortgages, or business buyouts without selling assets.
- Creditor and divorce protection: Trust-held proceeds can be distributed under terms that limit claims against the funds by beneficiaries’ creditors and sometimes insulate proceeds from spousal claims.
- Control of distributions: The grantor sets distribution rules (e.g., ages, education, health, support) that trustees follow after death.
(For broader context on life insurance in estate plans, see our guide on life insurance in estate planning.)
Key legal and tax rules to know
- Irrevocability: An ILIT is, by design, irrevocable. The grantor typically cannot change beneficiaries or reclaim ownership without tax consequences.
- Incidents of ownership: If the grantor retains ‘incidents of ownership’ (the ability to change beneficiaries, borrow against the policy, surrender it, or otherwise control it), the policy can be included in the grantor’s estate. Avoid retaining these powers if estate-tax exclusion is the goal [IRS — Tax Topics: Life Insurance].
- The three-year lookback rule: Transfers of life insurance (ownership transfers) made less than three years before the insured’s death are generally included in the insured’s estate under Internal Revenue Code §2035. That means transferring a personally owned policy to an ILIT within three years of death usually won’t remove it from the estate.
- Gift tax and premium funding: Funding the ILIT to pay premiums usually requires annual gifts to the trust (often structured as Crummey gifts to qualify for the annual gift-tax exclusion) or large taxable gifts/estate tax leveraging. Annual gift-tax exclusion amounts are adjusted periodically—check current IRS guidance before relying on a specific dollar figure [IRS — Gift Tax].
How ILITs are typically funded
- Buying a new policy owned by the ILIT: The trust applies for and owns the policy from day one. The trustee is the owner and pays premiums using contributions from the grantor.
- Transferring an existing policy: The grantor assigns an existing, personally owned policy to the ILIT. Beware of the three-year rule and check whether the policy has loan balances or surrender charges.
- Premium funding methods:
- Annual Crummey gifts: The grantor makes annual gifts to the ILIT, and the trust gives beneficiaries temporary withdrawal rights (Crummey notices) to make the gifts present-interest gifts eligible for the annual exclusion.
- Lump-sum or term funding: Larger gifts or sales to an intentionally defective grantor trust (IDGT) strategies are advanced tax planning techniques for high-net-worth clients and should be handled by an estate planning lawyer.
Trustee duties and administration
The trustee runs the ILIT. Typical duties include:
- Receiving premium gifts and managing cash flow to pay premiums on time;
- Issuing annual Crummey notices (when applicable) to beneficiaries to preserve gift-tax exclusion eligibility;
- Filing trust tax returns if required and keeping records of gifts and premium payments;
- Handling the death benefit—collecting proceeds, paying estate bills, and making distributions according to the trust terms.
Choose a trustee who understands insurance administration or use a professional trustee (bank or trust company) when complexity or conflicts may arise.
Practical steps to set up an ILIT (typical checklist)
- Consult an estate planning attorney experienced with ILITs.
- Decide whether the ILIT will buy a new policy or receive an existing policy by assignment.
- Draft trust terms addressing distribution timing, trustees’ powers, and successor trustees.
- Name an independent trustee (or corporate trustee) and successor trustees.
- Define premium funding plan (annual Crummey gifts or other funding) and document procedures for notices.
- Execute assignment (if transferring a policy) and confirm carrier approves owner change.
- Maintain documentation, send Crummey notices when necessary, and review the ILIT periodically.
Common mistakes and how to avoid them
- Transferring close to death: Moving a policy to an ILIT within three years of death can cause inclusion in the estate. Avoid last-minute transfers.
- Retaining ownership rights: Don’t keep powers such as the ability to change beneficiaries or borrow against the policy; those are ‘incidents of ownership’ and defeat the ILIT purpose.
- Missing Crummey formalities: If Crummey gifts are used, failing to provide proper notice or record beneficiaries’ temporary withdrawal rights can jeopardize use of the annual exclusion.
- Underfunding premiums: Ensure there’s a reliable funding plan; missed premiums can lapse the policy and nullify the plan.
- Not coordinating with other estate documents: Wills, powers of appointment, or business agreements may interact with the ILIT—coordinate across the plan.
Pros and cons
Pros:
- Removes a life insurance death benefit from the taxable estate when done correctly.
- Provides immediate liquidity to heirs.
- Offers distribution control and creditor protection.
Cons:
- Irrevocable: The grantor gives up control and typically cannot change trust terms.
- Administrative burden: Trustee duties, Crummey notices, and recordkeeping add complexity and cost.
- Timing constraints: The three-year rule and ownership rules require careful timing.
Real-world examples (anonymized)
Example 1 — Business liquidity:
A family business owner faced potential estate taxes and business succession challenges. We set up an ILIT that purchased a policy owned by the trust. At death, the ILIT’s proceeds funded a buy-sell agreement so the business could transfer to the next generation without forced sale. This prevented a liquidity crisis and preserved business continuity.
Example 2 — Paying estate settlement costs:
A retired couple created an ILIT to hold term-to-permanent policies. After one spouse’s death, the ILIT proceeds paid estate settlement and administrative expenses and equalized inheritances among children who did not work in the family business.
When an ILIT is a strong option
- When an estate is large enough that estate tax is a realistic concern;
- When illiquid assets (business, farmland, closely held stock) would be hard to sell quickly;
- When the grantor wants to control how life insurance proceeds are used by beneficiaries;
- When there is a need to protect proceeds from creditors or during a beneficiary’s divorce.
Alternatives and coordination
ILITs are one approach among many. Alternatives include direct ownership with beneficiary designations, payable-on-death accounts, or using other types of trusts (e.g., revocable trusts for different goals). Coordinate life insurance planning with your overall estate plan and review beneficiary designations regularly. See our guide on [life insurance in estate planning](
