Irrevocable life insurance trusts: careful design for the protection your policy provides

Most people buy life insurance with a particular family in mind. The policy is meant to replace income, pay off a home, provide for children or give a surviving spouse time to make decisions without pressure.

Who owns that policy matters as much as how large it is. Ownership determines whether the proceeds are counted in your taxable estate, who controls the money after your death and how it ultimately reaches the people you meant to protect.

An irrevocable life insurance trust, often called an ILIT, places those decisions in a document you design in advance. With careful planning, it can keep the proceeds outside your estate and hold them for your family on the terms you choose.

What is an irrevocable life insurance trust?

An ILIT is a trust created to own one or more life insurance policies, usually on your life. The trust is both the owner and the beneficiary of the policy. When the insured dies, the insurance company pays the proceeds to the trustee, who manages and distributes them under the trust’s terms.

You choose the trustee, the beneficiaries and the rules that guide distributions. Once the trust is signed, however, you cannot revoke it or reclaim the policy. That permanence is what allows the proceeds to be treated as outside your estate.

Why ownership of the policy matters

Life insurance proceeds are generally free of income tax. They are not automatically free of estate tax. If you own a policy on your own life, or keep certain rights over it at your death, the full death benefit is included in your taxable estate. Internal Revenue Code § 2042.

For 2026, each person may transfer up to $15 million during life or at death before federal estate tax applies, and married couples may be able to combine their exemptions. IRS: What’s new, estate and gift tax. Above that amount, the top federal rate is 40%. A substantial policy can be the asset that carries an otherwise comfortable estate past the exemption.

When the trust owns the policy from the start and you hold none of the rights the tax law describes as incidents of ownership, the proceeds can pass to your family without being counted in your estate. California has no separate estate or inheritance tax.

Thoughtful planning beyond estate tax

With the exemption at its current level, many families who consider an ILIT are not primarily concerned with estate tax. They want to decide how a significant sum of money will be handled when they are no longer here to guide it.

• Children who are young, or not yet ready. Proceeds left directly to a minor may require a court-supervised guardianship or another formal arrangement. A trust lets a trustee you select manage the funds and release them at ages or milestones you choose.
• A beneficiary with special needs. Proceeds can be held in a trust designed to supplement, rather than replace, needs-based public benefits. See our page on special needs trusts.
• Protection for what a child inherits. With appropriate terms, a continuing trust can offer protection against a beneficiary’s creditors or divorce. No structure protects against every claim.
• Blended families. A policy held in trust can provide for children from an earlier marriage while the rest of the estate provides for a current spouse.
• Liquidity when it is needed. Funds can be available to pay taxes, debts and expenses, buy out a business interest or equalize inheritances when a home or business will pass to one child.
• A spouse who is not a U.S. citizen. Insurance held outside the estate can simplify planning when the marital deduction is limited. See estate planning when a spouse is not a U.S. citizen.

The design is where the real work lies

An ILIT cannot easily be changed once it is signed, so the decisions made at the outset carry unusual weight. A well-designed trust anticipates the family it will serve years from now, not only the family as it is today.

• The trustee. You generally should not serve as trustee of a trust that holds insurance on your life. Many clients choose a trusted family member or an independent trustee, with a clear plan for successors. Any power you keep to replace a trustee must be drafted carefully.
• Distributions. The trust can pay out at your death or continue for your children and later generations. The standard you set, whether broad discretion or support for health, education and maintenance, affects both protection and flexibility.
• Withdrawal rights. These temporary rights, described below, allow premium gifts to qualify for the annual exclusion. They must be drafted so that they work as intended without creating unintended gifts among beneficiaries.
• Income tax status. Many ILITs are designed as grantor trusts, so that any trust income is reported on your own return. That choice can also make later policy transfers between trusts more efficient.
• Generations to come. A trust meant to last beyond your children requires attention to the generation-skipping transfer tax and to the allocation of your exemption from it.
• Flexibility for the future. Provisions such as a trust protector, or a power to replace a policy that no longer serves the family, can help the trust adapt without undoing the plan. California law also offers limited ways to modify an irrevocable trust. See trust modification petitions.

Funding the premiums with annual gifts

The trust usually has no income of its own, so you make gifts to the trust each year and the trustee uses them to pay the premiums. Those gifts are planned so that they use as little of your lifetime exemption as possible.

For 2026, you may give up to $19,000 to each recipient without using any of your lifetime exemption. IRS: Frequently asked questions on gift taxes. A married couple who elect to split their gifts may give up to $38,000 per recipient. The amount is adjusted for inflation from time to time, so the plan should be reviewed periodically.

A gift to a trust is ordinarily a gift of a future interest, which does not qualify for the annual exclusion. The trust therefore gives each beneficiary a temporary right to withdraw a share of each contribution, typically for 30 days. These rights are often called Crummey powers, after a 1968 decision of the federal Ninth Circuit Court of Appeals, which hears appeals from California. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).

In practice, the cycle follows a steady rhythm. You make the gift to the trust. The trustee sends each beneficiary a written notice of the right to withdraw. After the window closes without a withdrawal, the trustee pays the premium from the trust’s account.

Consider a married couple with three adult children who are beneficiaries of their ILIT. By splitting their gifts, they may contribute up to $114,000 in 2026 within their combined annual exclusions. Premium gifts above that amount, or gifts that do not qualify, use part of their lifetime exemption and must be reported on a federal gift tax return. IRS gift tax instructions.

A trust that will benefit grandchildren raises a separate question. Premium gifts that qualify for the gift tax annual exclusion often do not qualify for the generation-skipping transfer tax exclusion, so exemption may need to be allocated each year. Your CPA and our office coordinate that reporting.

Working alongside your insurance professional

An ILIT works only as well as the policy it holds, and the policy works best when it is chosen with the trust in mind. Our office does not sell insurance. Our role is to design the trust and guide its administration, and we are glad to work with the insurance professional you already know and trust, so the legal design and the coverage support the same goals.

• Sequence and timing. The trust is ordinarily signed before the application is submitted, so that the trust is the original applicant, owner and beneficiary. Your insurance professional coordinates underwriting around that timeline.
• The right kind of coverage. Term, permanent and survivorship policies, which pay at the second spouse’s death, each suit different purposes. The choice should reflect the family’s needs, the length of time coverage is required and the estate plan as a whole.
• A premium schedule the gifts can support. The premiums should fit within an annual gifting plan you can sustain. Policy illustrations deserve careful review, including which values are guaranteed and how the policy performs under less favorable assumptions.
• Reviews over time. Policies should be reviewed periodically to confirm that they remain on track. The trustee has a duty to manage the policy prudently, and that includes understanding how it is performing.

For insurance professionals. Attorney Cynthia Lee has worked alongside insurance professionals throughout her practice, and we welcome the opportunity to work with you and your clients. A client you introduce to our office becomes our client, and our advice is given independently and in that client’s interest. We design the trust around the client’s goals, consider how the coverage fits within the overall estate plan and, with the client’s permission, coordinate with you so the trust is in place before the policy is issued. Contact our office to arrange an introduction.

When you already own a policy

An existing policy can often be transferred to an ILIT. If you die within three years of the transfer, however, the proceeds are generally included in your estate. Internal Revenue Code § 2035. The gift is valued based on the policy’s worth at the time of the transfer, which an insurer can document.

Where health and insurability permit, the trust may instead acquire a new policy, with the existing coverage kept in place until the new policy is issued. Group coverage through an employer often cannot be transferred at all. Sales of policies between parties can raise income tax issues that a properly designed grantor trust may avoid.

What you give up, and what the trust requires

An ILIT is a permanent decision. You give up the right to change beneficiaries, borrow against the policy or draw on its cash value. Your trustee will need to keep records, send withdrawal notices, pay premiums on time and, in many cases, obtain a tax identification number for the trust.

The trust also does not replace the rest of your plan. Your living trust, will and powers of attorney remain its foundation, and the ILIT addresses a specific asset with a specific purpose.

Begin with the family you are planning for

A conversation about an ILIT starts with the people the policy is meant to protect. From there, we consider the size of your estate, the coverage you hold or are considering and how the proceeds should be managed after your death.

At American Trust Institute, we design irrevocable life insurance trusts in coordination with your insurance professional and CPA, so the trust, the policy and the gifting plan work together from the first premium. You can also see a step-by-step illustration of how a life insurance trust works.

Attorney Cynthia Lee personally designs and reviews every plan. Consultations are available in English, Cantonese or Mandarin, by Zoom or at our San Jose and San Francisco offices. Request an appointment to discuss a life insurance trust.