Irrevocable Life Insurance Trust (ILIT): How Does It Work?

An Irrevocable Life Insurance Trust (ILIT) is a special type of trust that can help reduce estate taxes and protect life insurance proceeds for your beneficiaries. This type of trust owns and controls your life insurance policy, keeping the death benefit outside your taxable estate.

It's typically a good option for high-net-worth individuals with substantial estates who want to maximize the inheritance they pass to their heirs. Here's everything you need to know.

What Is an Irrevocable Life Insurance Trust (ILIT)?

An ILIT is a permanent, irrevocable trust that owns a life insurance policy on your life. Once you create the trust and transfer your policy into it, you no longer legally own the policy. Instead, the trust becomes the owner and beneficiary.

This separation is important because it removes the life insurance proceeds from your taxable estate.

The trust has a tax identification number and requires a trustee (someone other than you) to manage it according to the terms you establish when creating the trust.

Related Article | How to Avoid Inheritance Tax with a Trust

How Does an Irrevocable Life Insurance Trust Work?

Here's a step-by-step breakdown of how an Irrevocable Life Insurance Trust works:

You establish the trust with the help of an estate planning attorney or a qualified financial professional.
The trust purchases a new policy on your life (or you can transfer an existing life insurance policy into the trust, but it comes with certain tax considerations).
You make cash gifts to the trust to pay the annual insurance premiums.
The trustee sends "Crummey notices" to beneficiaries, giving them temporary withdrawal rights to these gifts (making them "present interest" gifts eligible for the annual gift tax exclusion).
Upon your death, the insurance payout goes straight to the trust rather than becoming part of the property you leave behind.
The trustee distributes these funds to your beneficiaries according to the terms you established in the trust document.

When you pass away, the federal government assesses estate taxes on the total value of everything you own that exceeds the estate tax exemption amount (currently $13.99 million in 2025, but expected to drop to around $6 million by 2026).

Any amount over this threshold gets taxed at rates up to 40%. Some states also impose their own estate taxes with lower exemption thresholds.

Life insurance death benefits are normally included in your taxable estate if you owned the policy. But when an ILIT owns the policy instead, those proceeds aren't counted as part of your estate.

This can save your heirs hundreds of thousands or even millions in estate taxes, depending on your situation.

Related Article | How to Pass Money to Heirs Tax-Free

What Is the 3-Year Rule for Irrevocable Life Insurance Trust?

The 3-year rule is an important IRS regulation that affects the transfer of existing life insurance policies to an ILIT. This rule states that if you transfer an existing life insurance policy to an ILIT and then die within 3 years of the transfer date, the death benefit will still be counted as part of your taxable estate, even though the ILIT technically owned the policy when you died.

Irrevocable Life Insurance Trust Example

James has a total estate worth $15 million, including his business, investments, and personal property. He's concerned about estate taxes reducing his children's inheritance.

James creates an ILIT and names his adult daughter as trustee. The trust purchases a $5 million life insurance policy on James's life. Each year, James gifts $30,000 to the trust to cover the premium payments. The trustee sends Crummey notices to James's three children, giving them temporary rights to withdraw portions of these gifts.

When James passes away, the insurance company pays $5 million directly to the ILIT. This money isn't part of James's taxable estate. The trustee then distributes these funds to James's children according to the trust's terms, providing each with a tax-free inheritance that wasn't reduced by estate taxes. The rest of James's estate goes through the normal probate and estate tax process.

What Is the Purpose of Creating an Irrevocable Life Insurance Trust?

The main purpose of an ILIT is to remove life insurance proceeds from your taxable estate and minimize estate taxes. When you place your life insurance policy in this trust, you can potentially save your heirs hundreds of thousands of dollars. ILITs also offer asset protection from creditors.

Irrevocable Life Insurance Trust: Pros and Cons

Irrevocable Life Insurance Trusts work best for individuals with larger estates who want to minimize federal estate taxes and provide tax-free benefits to heirs.

However, it may not be suitable for those who need flexibility to adapt to changing circumstances or who don't have estates large enough to worry about having to pay estate taxes.

Benefits of an Irrevocable Life Insurance Trust

Here's how you can benefit from an ILIT:

Estate Tax Savings: By keeping life insurance proceeds outside your taxable estate, an ILIT can significantly reduce or eliminate estate taxes.
Creditor Protection: The trust structure helps shield insurance proceeds from creditors, lawsuits, and divorce settlements.
Control Over Distributions: You decide how and when beneficiaries receive the money, which is helpful for beneficiaries who may not manage money well.
Avoids Probate: Insurance proceeds in an ILIT bypass the time-consuming and potentially costly probate process.
Special Needs Planning: ILITs can provide for children or family members with special needs without disqualifying them from government benefits.

In short, this type of irrevocable trust can help you make the most out of your life insurance benefits.

What Are the Disadvantages of Life Insurance in a Trust?

At the same time, there are also certain disadvantages of an ILIT to consider:

Irrevocable Nature: Once established, you can't change or dissolve the trust, even if your circumstances change in the future.
Loss of Control: You must give up ownership rights to the insurance policy and can't borrow against it or access its cash value.
Administrative Complexity: ILITs require ongoing maintenance, including annual Crummey notices, separate tax ID numbers, and annual tax filings.
Costs: Creating and maintaining an ILIT involves attorney fees, trustee fees, and potentially accounting costs.
Premium Funding Limitations: Gifts to the trust to pay premiums are subject to gift tax rules, which can complicate funding larger policies.
3-Year Rule Risk: Transferring existing policies carries the risk of inclusion in your estate if you die within 3 years of the transfer.

If you have substantial wealth and want to use an Irrevocable Life Insurance Trust for estate tax purposes, make sure to consult with an attorney or estate planning professional first.

Related Article | What Is a Dynasty Trust and How Does It Work?

So, Is an Irrevocable Life Insurance Trust a Good Idea for You?

You're likely a good candidate for an ILIT if your estate exceeds or may exceed the federal estate tax exemption amount, you have specific wishes about how life insurance proceeds should be distributed, or you want to protect assets from creditors.

An ILIT also makes sense if you're a business owner needing liquidity for succession planning or if you have family members with special needs.

However, an ILIT probably isn't right for you if your estate is well below the estate tax threshold, you need flexibility to change your financial plans, or you might need access to the cash value of your policy in the future.

The costs and complexity of an ILIT simply may not be worth it if you don't have estate tax concerns. If you're still building wealth or your financial situation is likely to change significantly, you might want to consider more flexible options.

FAQs

What Is an Estate Tax?

Estate tax is a tax imposed by the federal government (and some states) on the transfer of property after someone dies. The tax applies to your entire taxable estate, all your assets minus allowable deductions, that exceed the exemption threshold ($13.99 million in 2025, but expected to drop to around $6 million by 2026). Unlike inheritance tax (which is paid by beneficiaries), estate tax is paid from the estate before assets are distributed to heirs.

How to Set Up an Irrevocable Life Insurance Trust?

You'll need to work with an experienced estate planning attorney who will draft the trust document according to your specific needs and goals. You'll need to select a trustee, identify beneficiaries, and determine trust distribution terms. Once the trust is established, you'll either transfer an existing life insurance policy to it (subject to the 3-year rule) or the trust will purchase a new policy on your life. You'll then need to fund the trust through annual gifts that enable the trustee to pay the insurance premiums, followed by sending Crummey notices to beneficiaries to qualify for the annual gift tax exclusion.

How to Terminate an Irrevocable Life Insurance Trust?

Terminating an Irrevocable Life Insurance Trust isn't a straightforward process. However, despite its "irrevocable" name, there are a few ways to potentially terminate an ILIT. The simplest method is to stop funding it because if no further premium payments are made, the insurance policy will eventually lapse. Alternatively, all beneficiaries can agree to terminate the trust if state law permits. Some states allow for "decanting," which transfers assets from the old trust to a new one with different terms. Court intervention is another option if circumstances have changed, but generally speaking, irrevocable trusts aren't that easy to terminate.

Do I Need to File a Tax Return for an Irrevocable Life Insurance Trust?

Yes, an ILIT generally needs to file an annual tax return (Form 1041) if it generates more than $600 in income during the tax year. Most ILITs have minimal income since their primary asset is a life insurance policy, but if the trust holds other investments or if premium payments exceed what's needed and earn interest, tax filing is required. Additionally, if the trust makes distributions of income to beneficiaries, it must issue Schedule K-1 forms. The trustee is responsible for ensuring all tax obligations are met, usually with help from an accountant familiar with trust taxation.

Can You Change the Beneficiary of an Irrevocable Life Insurance Trust?

It depends, but it may not be easy. If the trust includes provisions that allow for beneficiary modifications, the trustee may have the power to change beneficiaries according to those specific terms. Some ILITs grant someone (often the grantor's spouse) a "limited power of appointment" to redirect assets among a defined group of potential beneficiaries. Without such provisions, beneficiary changes are generally not possible without court approval or unanimous consent from all current beneficiaries.

Can You Withdraw from an ILIT?

As the grantor (creator) of an ILIT, you can't withdraw funds from the trust. This is a key requirement for keeping the insurance proceeds out of your taxable estate. The beneficiaries, however, may have limited withdrawal rights through the "Crummey power" provision, which gives them a temporary window to withdraw gifted funds before those gifts are used to pay premiums. Outside of these specific Crummey withdrawal provisions, beneficiaries generally can't access trust assets until the triggering event occurs (typically the death of the insured) and then only according to the distribution terms established in the trust document.

Who Pays Taxes on ILIT Income?

An ILIT is a separate taxpayer with its own tax identification number. If the trust retains income rather than distributing it, the trust itself pays taxes on that income at compressed trust tax rates, which reach the highest tax brackets much faster than individual rates. If the trust distributes income to beneficiaries, the beneficiaries generally pay taxes on that income at their individual tax rates, and the trust takes a distribution deduction. The life insurance death benefit itself is typically income-tax-free. However, any interest or investment returns generated by the death proceeds after they're paid to the trust may be taxable.

The Bottom Line

An Irrevocable Life Insurance Trust can help high-net-worth individuals with substantial estate assets reduce estate taxes and provide for their heirs. However, the irrevocable nature of the ILIT can make it quite inflexible.

Make sure to consult experienced estate planning professionals to make sure that an ILIT aligns with your goals, or if you should investigate other trust options or life insurance products.