How Life Insurance in an Irrevocable Life Insurance Trust Really Works

In advanced planning, few tools have stood the test of time like the Irrevocable Life Insurance Trust, or ILIT.

It sounds complicated, but the goal is simply to remove life insurance from your taxable estate while still ensuring your family can use the proceeds exactly the way you intend. For many high-net-worth families, that combination of control and tax efficiency is why ILITs remain a foundational part of wealth transfer planning.

So let’s get back to basics. First we will share why ILITs still matter. Then, we will discuss how an ILIT works, step-by-step. We are going to walk though how it’s set up, how it operates, and what happens when the plan finally comes full circle at death.

Why ILITs Still Matter

With today’s high federal estate tax exemption ($15 million per person, $30 million per couple as of 2025), some families assume ILITs are outdated. But as evidenced by our current political climate, nothing is certain and one election can change the tax code drastically.

For many affluent families, that means estate exposure could return quickly, and life insurance held inside an ILIT remains one of the cleanest, most flexible ways to create estate liquidity and generational protection.

Beyond taxes, ILITs provide control, privacy, and predictability. They help ensure your heirs receive the benefit without delays, disputes, or forced sales. And they integrate seamlessly with other planning structures like Spousal Lifetime Access Trusts (SLATs) or Dynasty Trusts for long-term wealth preservation.

Step 1: Setting Up the ILIT (Separating Ownership from Control)

The first thing to know is that you don’t own the life insurance policy. The trust does.

An ILIT is a separate legal entity created to own and control one or more life insurance policies on your life. Because you give up ownership and the ability to change the trust, the IRS no longer counts the policy’s death benefit as part of your estate.

Here’s the basic setup:

• You (the grantor) work with your estate attorney to create the trust.

• You name a trustee (often a trusted family member or professional fiduciary) to manage it.

• The beneficiaries (your spouse, children, or others) are clearly defined.

• Once the trust is signed, it receives its own tax ID number and becomes a standalone entity.

  
  

From there, the ILIT either purchases a new life insurance policy on your life or, less commonly, you transfer an existing one. (If you transfer an old policy, you’ll need to live at least three years after the transfer for the proceeds to stay outside your taxable estate.)

Step 2: Funding the Trust and Paying Premiums

Because the ILIT owns the policy, it also has to pay the premiums. That means you can’t pay them directly and you have to fund the trust instead.

Each year, you make a gift to the ILIT. The trustee then uses those funds to pay the insurance company. To make those gifts tax-free, the trust includes what are called Crummey powers, a quirky but effective feature that gives beneficiaries a short-term right to withdraw their portion of your gift.

In practice, it works like this:

1. You gift money to the ILIT.

2. The trustee notifies the beneficiaries that they can withdraw it (they usually don’t).

3. After a brief window, the trustee uses the funds to pay the life insurance premium.

   
   

The end result? The policy stays current, your gifts qualify for the annual exclusion, and the trust remains compliant.

Step 3: The Three-Year Rule (Timing Matters)

If the ILIT buys a new policy, the proceeds are excluded from your taxable estate immediately.

If you transfer an existing policy, though, the IRS applies a three-year lookback. You need to survive for three years after the transfer for the death benefit to be excluded. Otherwise, it gets pulled back into your estate.

That’s why many ILITs are designed from the start to purchase new coverage.

Step 4: Managing the ILIT During Life

Once the structure is in place, the ILIT becomes a living part of your estate plan. The trustee’s responsibilities include:

• Keeping the policy in force by paying premiums on time.

• Maintaining records of Crummey notices and annual gifts.

• Coordinating with your advisors to ensure the policy’s performance and trust provisions still fit your goals.

  
  

Although you can stay informed, you can’t control how the trustee manages the trust or alter its terms. That’s the trade-off that creates the estate tax benefit.

Step 5: What Happens at Death (The ILIT in Action)

When you pass away, the life insurance company pays the death benefit directly to the ILIT, not to your estate.

That’s the moment all the careful planning pays off. Because the ILIT, not you, owns the policy, the proceeds are not subject to estate tax. The trustee can then use the funds to:

• Provide liquidity to your estate, often by lending or purchasing assets from it, so your heirs don’t have to sell real estate or a family business to pay estate taxes.

• Support your spouse or children according to the terms you outlined.

• Equalize inheritances among family members.

• Fund charitable gifts or multigenerational trusts that carry on your legacy.

  
  

The trustee distributes or invests the proceeds based on the instructions you built into the ILIT document, ensuring your wealth is managed and protected the way you intended.

Back to Basics, Big Impact

Sometimes the simplest tools are the most powerful. An ILIT may not make headlines like premium finance or private placement structures, but it often forms the bedrock those strategies rest on.

When designed correctly, an ILIT can transform a simple life insurance policy into a strategic estate planning asset that provides liquidity, protects legacy, and gives your family the freedom to focus on what really matters.

This material is for informational purposes only and does not constitute legal, tax, or financial advice. Individuals should consult their own professional advisors before making any decisions.