Why liquidity at death matters

When someone dies, heirs and executors often need cash quickly to pay final expenses, debts, probate costs, and — if applicable — estate taxes. Without ready cash, families may be forced to sell illiquid assets such as a family business, real estate, or investment holdings at inopportune times. A life insurance trust provides a pre-funded, tax-efficient source of funds that can be distributed quickly to meet these obligations.

(For background on how life insurance fits into broader estate plans, see the FinHelp article “Life Insurance in Estate Plans: Uses and Pitfalls.”)

How a life insurance trust works — plain language

  • The grantor (the person buying the trust) creates an irrevocable trust and names a trustee and beneficiaries.
  • The trust purchases a new life insurance policy or becomes the owner of an existing policy.
  • The trust pays the premiums (often using gifts from the grantor), and controls the death benefit distribution after the insured dies.
  • Because the trust — not the insured — owns the policy, the death proceeds generally are not included in the insured’s taxable estate, so they arrive to the trust free of income tax and typically free of federal estate tax.

Key practical note from my practice: many clients prefer the trust to own a new policy written directly in the trust’s name. That avoids transfer issues and the three‑year look‑back rule (explained below) that can pull proceeds back into the estate if the insured dies shortly after transferring a policy.

Typical uses of an ILIT to provide liquidity

  • Pay federal or state estate taxes without selling assets.
  • Satisfy outstanding debts and final medical or funeral expenses.
  • Provide a cash cushion so executors can wind up an estate orderly.
  • Equalize inheritances (for example, provide liquid benefits to children who did not inherit specific real estate). (Related: “Using Life Insurance Trusts to Equalize Inheritances.”)

Two common ways to fund an ILIT

1) New-policy ILIT: The trust purchases a life insurance policy at inception. The grantor usually contributes money to the trust to cover premium payments or the trust is structured to pay premiums directly.
2) Transferring an existing policy: The grantor transfers ownership of a policy he or she already owns into the trust. This is often done when the policy has favorable underwriting or cash value.

Both approaches work, but each has tax and administrative consequences.

Important tax rules and administrative mechanics (what to watch for)

  • Three-year rule: Under Internal Revenue Code §2035, if the insured transfers an existing policy to another owner (including an ILIT) and dies within three years, the proceeds can be included in the insured’s estate. That can defeat the purpose of the trust if death occurs inside that window. (See IRS guidance on estate tax rules.)

  • Gift tax and Crummey powers: When you fund an ILIT so it can pay premiums, those contributions are often treated as gifts to the trust beneficiaries. To let each premium-contribution qualify for the annual gift tax exclusion, trustees typically issue short-term withdrawal rights (so-called Crummey notices) to beneficiaries. Those notices let beneficiaries withdraw the gift for a short period, making the contribution a present interest eligible for the annual exclusion. (Crummey powers are a longstanding estate-planning technique; check IRS gift-tax resources.)

  • Premium payment mechanics: The grantor can give the trust money each year to pay premiums (often via annual gifts), or the trust can own a paid-up policy. Proper documentation and timely Crummey notices are essential to avoid unintended gift-tax results.

  • State estate taxes and ancillary costs: Some states have estate or inheritance taxes with smaller exemptions than the federal level. A well-designed ILIT takes state issues into account because federal exclusion amounts and state rules differ. Always confirm state rules with your advisor.

  • Policy loans and cash value: If the trust owns a permanent policy with cash value, the trust’s terms must specify whether the trustee can borrow from or access that value. If the trust is the policy owner, the grantor will generally lose personal access to policy loans or cash-surrender value.

Practical example (illustrative)

Imagine an owner has a family farm and expects an estate tax bill that could require selling part of the property. The owner creates an ILIT that buys a policy sized to produce the estimated tax liability. At death, the insurer pays the trust; the trustee uses the proceeds to pay taxes and preserve the family farm.

This is an illustrative example only. Actual amounts, tax treatment, and estate exposures vary by individual circumstances.

Choosing the trustee and drafting points

  • Trustee selection: Choose someone trustworthy, financially literate, and comfortable with the role. Many grantors name a professional trustee (bank, trust company, or attorney) when sophistication or potential conflicts exist.
  • Trust terms: The trust document should specify beneficiary classes, distribution standards (income vs. principal), the trustee’s powers to invest or borrow, and whether the trust may purchase or exchange policies.
  • Irrevocability: Most ILITs are irrevocable. That permanence creates tax benefits but limits flexibility; consider whether you may later need access to policy cash value or the ability to change beneficiaries.

Common mistakes and how to avoid them

  • Transferring a policy too close to death: The three‑year rule can undo your plan — start early.
  • Failing to use Crummey notices: Without them, premium gifts may not qualify for the annual gift-tax exclusion, possibly causing unexpected taxable gifts.
  • Picking the wrong trustee: The wrong trustee can delay claim payments or mismanage proceeds during a sensitive period.
  • Overlooking state tax exposure: Federal exclusion planning can miss smaller state exemptions.
  • Ignoring insurer requirements: Some carriers treat transfers differently (e.g., require insurability exams or impose consent-to-transfer forms). Coordinate with the insurer before transferring ownership.

Alternatives and complements

Not every family needs an ILIT. Alternatives include:

  • Personal ownership with a liquidity reserve elsewhere (e.g., a taxable investment account earmarked for estate costs).
  • Corporate-owned life insurance (for business owners) or buy-sell insurance arrangements.
  • Trust-owned policies with more flexible distributions but different tax outcomes.

If you want strategies that use life insurance but avoid an ILIT, see FinHelp’s piece “Leveraging Life Insurance for Estate Liquidity Without an ILIT.”

Practical checklist to set up an ILIT (high-level)

  1. Talk with an estate planning attorney and tax advisor to confirm objectives.
  2. Decide whether to purchase a new policy in the trust or transfer an existing one.
  3. Draft and fund the ILIT with clear Crummey powers and trustee instructions.
  4. Document annual gifts, provide timely Crummey notices to beneficiaries, and maintain records.
  5. Coordinate with the insurer for policy issue/transfer and beneficiary updates.
  6. Review the arrangement periodically or after major life events.

Costs and trade-offs

  • Setup and administration: Legal drafting, trustee fees, and annual administration costs are real.
  • Loss of flexibility: Irrevocability means you can’t easily change terms or reclaim policy cash value.
  • Insurability risk: If you transfer an existing policy, you remain covered; if you buy a new policy in older age, underwriting can be more expensive.

Final considerations and next steps

Life insurance trusts are a powerful tool to secure immediate liquidity at death and shelter life insurance proceeds from estate inclusion when properly structured. They are most useful when the estate holds illiquid assets, there’s an expected estate tax exposure, or the family needs orderly liquidity to protect a business or property.

Because federal and state tax rules change and the details matter, consult an estate planning attorney and a qualified financial professional before creating or funding any trust. This article is educational and not a substitute for personal legal or tax advice.

Authoritative resources

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Professional disclaimer: This content is educational and does not constitute legal, tax, or investment advice. For advice tailored to your situation, consult a qualified estate planning attorney, tax advisor, or CFP® professional.