Irrevocable Life Insurance Trusts

Irrevocable Life Insurance Trust (ILIT): Keeping Life Insurance Proceeds Outside Your Taxable Estate

Life insurance is designed to provide for your family after you are gone. But if the policy is owned by you at your death, the proceeds are included in your taxable estate and subject to Vermont and federal estate tax. An Irrevocable Life Insurance Trust removes the policy and its death benefit from your estate entirely, providing tax-free liquidity to your family precisely when they need it most.

An Irrevocable Life Insurance Trust (ILIT) is a legal arrangement in which an irrevocable trust owns one or more life insurance policies on the grantor's life. Because the trust, rather than the insured, owns the policy, the death benefit proceeds are not included in the insured's taxable estate at death. The proceeds pass to the trust's beneficiaries income-tax free and estate-tax free, providing a clean and efficient transfer of wealth precisely when the family's need for liquidity is greatest.

Without an ILIT, life insurance proceeds received by the insured's estate are subject to Vermont and federal estate tax along with every other asset in the estate. For Vermont families with estates above the $5,000,000 Vermont exemption threshold, that can mean 16% of the death benefit is paid to the state of Vermont rather than to the family. For large estates subject to federal estate tax as well, the combined tax on the proceeds can be substantial. An ILIT eliminates both.

An ILIT is particularly important for two categories of families: those with large estates who need a tax-efficient way to provide liquidity to pay estate taxes without forcing the sale of business interests or other illiquid assets, and those with closely held businesses or farms who need to provide cash for buy-sell arrangements or to equalize inheritances among heirs.

If you own a life insurance policy at the time of your death, the full death benefit is included in your taxable estate. A $2,000,000 policy owned by a Vermont decedent with a taxable estate above $5,000,000 could generate $320,000 in Vermont estate tax on the policy proceeds alone. An ILIT eliminates that exposure entirely.

Step 1: Create the Trust

The grantor works with an estate planning attorney to establish the ILIT as an irrevocable trust. The trust document identifies the beneficiaries, specifies how the proceeds are to be distributed at the grantor's death, and appoints a trustee who is not the grantor. Because the trust is irrevocable, its terms cannot be changed once established, and the grantor cannot serve as trustee without risking inclusion of the policy in the estate.

Step 2: Transfer the Policy or Apply for a New One

There are two ways to fund an ILIT. The grantor can transfer an existing life insurance policy into the trust, or the trust can apply for and own a new policy from inception. Transferring an existing policy is subject to a three-year lookback rule: if the grantor dies within three years of transferring an existing policy to the ILIT, the proceeds are pulled back into the taxable estate. For this reason, having the ILIT apply for a new policy directly, rather than transferring an existing one, is generally the preferred approach when possible. Once the ILIT owns the policy, the death benefit is outside the estate from the start.

Step 3: Fund Premium Payments Using the Annual Gift Exclusion

The ILIT does not have independent income to pay premiums. The grantor makes annual gifts to the trust, which the trustee uses to pay the policy premiums. To ensure these gifts qualify for the annual gift tax exclusion and do not consume the grantor's lifetime exemption, the ILIT must include “Crummey provisions,” named after a landmark tax case, that give each beneficiary a temporary right to withdraw their share of the annual gift before the trustee uses it for premium payments. The trustee sends written notice of this withdrawal right to each beneficiary annually; in practice, the beneficiaries do not exercise it, but the notice is legally required to qualify the gifts for the annual exclusion.

For 2026, the annual gift tax exclusion is $19,000 per beneficiary. A grantor with three beneficiaries can contribute up to $57,000 per year to the ILIT gift-tax free for premium payments. A married couple can combine exclusions and contribute $38,000 per beneficiary annually.

Step 4: The Grantor Dies and the Proceeds Are Paid

When the grantor dies, the life insurance company pays the death benefit to the ILIT. Because the trust owns the policy and the grantor did not retain any incidents of ownership, the proceeds are not included in the grantor's taxable estate. The proceeds are also received income-tax free by the trust, as life insurance death benefits generally are.

Step 5: The Trustee Distributes the Proceeds

The trustee distributes the proceeds to the trust's beneficiaries according to the terms of the trust document. The distribution can be outright or held in trust for the beneficiaries' benefit, with conditions and timing specified by the grantor in the original trust document. Alternatively, and very commonly for estate-tax-planning ILITs, the trustee may make distributions or loans from the trust to the grantor's estate to provide the liquidity needed to pay estate taxes without requiring a forced sale of other assets.

•      Life insurance proceeds outside the taxable estate: The death benefit is not included in the grantor's taxable estate for Vermont or federal estate tax purposes, eliminating what could otherwise be a substantial estate tax on the policy proceeds.

•      Tax-free liquidity at the moment of greatest need: Life insurance proceeds received by the ILIT are income-tax free and estate-tax free. The family receives the full death benefit without reduction for taxes, providing clean liquidity at the moment the family most needs financial resources.

•      Funds to pay estate taxes without forced sales: For large estates, the ILIT's proceeds can be used to pay Vermont and federal estate tax obligations, preventing the family from having to sell a business, farm, or other illiquid asset under unfavorable conditions to meet a tax deadline.

•      Business succession liquidity: For closely held business owners, an ILIT can provide the cash needed to fund a buy-sell agreement, allowing family members to purchase a deceased owner's interest from the estate without requiring the business to be sold to outside parties.

•      Asset protection: Assets held in a properly structured ILIT are generally not reachable by creditors of either the grantor or the trust's beneficiaries, providing an additional layer of protection for the insurance proceeds.

•      Privacy: Because the ILIT is not subject to probate, the identity of the beneficiaries and the amount of the death benefit are not part of the public record.

•      Control over distribution: The grantor specifies in the trust document exactly how and when the proceeds are to be distributed, ensuring that the death benefit serves its intended purpose rather than being received outright by beneficiaries who may not be equipped to manage a large sum.

Vermont's 16% estate tax on estates above $5,000,000 makes an ILIT particularly valuable for Vermont families. Life insurance is frequently used as the primary source of liquidity in an estate plan, and without an ILIT, a significant portion of that liquidity is immediately consumed by Vermont estate tax on the policy proceeds themselves.

An ILIT removes the policy from the Vermont taxable estate entirely. The full death benefit reaches the family, providing the liquidity needed to pay any remaining Vermont or federal estate tax on other assets without forcing sales of business interests, real estate, or investment portfolios.

For Vermont families who have already used other estate tax planning strategies, including Credit Shelter Trusts, SLATs, or IDGTs, an ILIT complements those strategies by ensuring that the liquidity needed to pay remaining tax obligations is available outside the estate, preserving the value of the estate planning strategies already in place.

The Three-Year Rule for Transferred Policies

If the grantor transfers an existing policy to the ILIT and dies within three years of the transfer, the death benefit is included in the taxable estate as though the transfer never occurred. This risk is entirely avoided by having the ILIT apply for and own a new policy from inception rather than transferring an existing one. If an existing policy must be transferred, the grantor should plan their ILIT around the three-year lookback period.

Incidents of Ownership

For the ILIT to remove the death benefit from the estate, the grantor must not retain any “incidents of ownership” over the policy. Incidents of ownership include the right to change the beneficiary, the right to surrender or cancel the policy, the right to assign the policy, and the right to borrow against the policy's cash value. If the grantor retains any of these rights, the policy is included in the estate regardless of who technically owns it. The grantor must not serve as trustee of the ILIT for this reason.

Crummey Notices Must Be Sent Annually

The annual premium payments made by the grantor to the ILIT qualify for the gift tax annual exclusion only if the beneficiaries receive proper written notice of their temporary withdrawal rights. These notices, called Crummey notices, must be sent to every beneficiary each year before the trustee uses the contributed funds to pay premiums. Failure to send proper and timely Crummey notices can disqualify the gifts from the annual exclusion, causing them to consume the grantor's lifetime exemption instead. This is an ongoing administrative obligation that requires consistent attention.

Why should I put my life insurance in a trust instead of naming my family directly as beneficiaries?

If you own the policy at your death, the full death benefit is included in your taxable estate even if you named your family as beneficiaries. Estate tax is calculated on the total value of your estate, including life insurance proceeds. An ILIT removes the policy from your estate entirely, so the full death benefit passes to your family free of Vermont and federal estate tax. For a Vermont estate above $5,000,000, this can save a significant portion of the death benefit that would otherwise go to estate taxes.

What is a Crummey notice and why does it matter?

A Crummey notice is the written notice that the trustee must send to each ILIT beneficiary annually after the grantor contributes funds for premium payments. The notice informs the beneficiary of their temporary right to withdraw their share of the contribution. This right must genuinely exist, even though beneficiaries typically do not exercise it, in order for the gift to qualify for the annual gift tax exclusion. Without proper and timely Crummey notices, the premium payments may be treated as taxable gifts that consume the grantor's lifetime exemption rather than the annual exclusion.

Can I be the trustee of my own ILIT?

No. If the grantor serves as the trustee of the ILIT, the IRS may treat the grantor as retaining incidents of ownership over the policy, which would cause the death benefit to be included in the grantor's taxable estate. The trustee must be someone other than the grantor, typically a trusted family member, a professional fiduciary, or a bank trust department. The grantor's spouse can serve as trustee in some circumstances, but this requires careful analysis to avoid unintended estate inclusion.

What happens to the ILIT if I stop paying premiums?

If the grantor stops making gifts to the ILIT, the trustee will have no funds to pay premiums. Depending on the type of policy, missed premium payments can cause the policy to lapse, use accumulated cash value to pay premiums until the cash value is exhausted, or reduce the death benefit. The grantor should ensure that the ILIT is structured with a policy type appropriate for the planned funding level and should consult with their financial advisor and estate planning attorney before changing the premium payment structure.

Can the ILIT use the proceeds to pay my estate taxes?

Yes, but it must be structured properly to do so. The ILIT proceeds cannot be paid directly to the estate, as doing so would cause the proceeds to be included in the taxable estate. Instead, the trustee can make loans to the estate at a reasonable interest rate or purchase estate assets at fair market value, providing the estate with liquidity to pay taxes without the proceeds being treated as estate assets. This liquidity mechanism must be anticipated in the trust document and requires coordinated planning between the ILIT trustee and the estate's executor.

How much life insurance should I put in an ILIT?

The right amount depends on your estate tax exposure and your family's liquidity needs. A common approach is to size the policy to cover the anticipated estate tax liability, so that the family does not have to sell any other assets to satisfy the tax bill. For business owners, the policy may also need to fund a buy-sell agreement. We work with your financial advisor and life insurance professional to coordinate the policy sizing with the overall estate plan.

Does an ILIT reduce Vermont estate taxes?

Yes. By placing a life insurance policy in an ILIT, the death benefit is removed from the Vermont taxable estate entirely. For Vermont families with estates above the $5,000,000 Vermont exemption threshold, this can produce significant Vermont estate tax savings on what would otherwise be a substantial policy death benefit included in the estate. The ILIT also preserves the liquidity needed to pay any remaining Vermont or federal estate tax on other assets without requiring forced sales.

Establishing an Irrevocable Life Insurance Trust requires careful drafting of the trust document, proper coordination with the life insurance company, timely transfer or application for the policy, annual Crummey notice compliance, and ongoing coordination between the trustee, the grantor, and the estate plan. Every one of these steps must be executed correctly; an ILIT that is improperly established or administered may fail to provide the estate tax protection it was designed to deliver.

At Will and Trust Planning, we prepare ILITs as part of comprehensive estate tax plans and as standalone instruments for clients with specific life insurance planning needs. We draft the trust document, coordinate with your financial advisors and life insurance professionals, establish the Crummey notice procedures, and provide the ongoing guidance needed to keep the trust in compliance throughout the grantor's lifetime.

Contact Will and Trust Planning Today

For personalized advice on estate planning, including strategies to minimize or avoid probate, contact Will and Trust Planning today. Our experienced estate planning attorneys can help you understand your options, draft essential documents, and create a plan that protects your assets and achieves your goals.