If you have a large life insurance policy, you may be surprised to learn that the death benefit could be subject to estate taxes.
Many people assume life insurance is always tax-free. And while the beneficiary does not pay income tax on the death benefit, the policy itself can still be included in your taxable estate.
The good news is that with proper planning, you can use a trust to keep life insurance proceeds out of your estate and reduce or eliminate estate taxes.
Is Life Insurance Subject to Estate Taxes?
Life insurance death benefits are income tax-free to the beneficiary.
But that does not mean they are estate tax-free.
If you own the policy when you die, the full death benefit is included in your taxable estate.
For example:
- You have a $2 million life insurance policy
- You own other assets worth $8 million
- Your total estate is $10 million
If your estate exceeds the federal estate tax exemption (which is $13.61 million in 2025, rising to $15 million in 2026), your estate could owe federal estate taxes.
Even if you are under the federal exemption, some states have their own estate taxes. Massachusetts, for example, has a much lower threshold.
How Does Putting Life Insurance in a Trust Reduce Estate Taxes?
When you put life insurance in a trust, the trust owns the policy, not you.
Because you do not own the policy, the death benefit is not included in your taxable estate.
This is called an Irrevocable Life Insurance Trust, or ILIT.
An ILIT can:
- Remove life insurance from your taxable estate
- Reduce or eliminate estate taxes
- Provide liquidity to pay estate taxes on other assets
- Protect the death benefit from creditors and divorce
For high-net-worth individuals and families in Massachusetts, an ILIT is one of the most effective estate tax planning tools.
What Is an Irrevocable Life Insurance Trust (ILIT)?
An ILIT is a trust specifically designed to own life insurance.
Here is how it works:
The trust is created
You (or your estate planning attorney) create an irrevocable trust document that names:
- A trustee
- Beneficiaries (typically your spouse and children)
- Terms for how the death benefit will be distributed
The trust owns the policy
Either the trust purchases a new life insurance policy, or you transfer an existing policy into the trust.
You make gifts to the trust
You gift money to the trust each year to pay the insurance premiums.
When you die, the death benefit goes to the trust
The insurance company pays the death benefit to the trust, not to you or your estate.
The trustee distributes the funds
The trustee uses the funds according to the terms of the trust (such as paying estate taxes, providing for your spouse, or distributing to children).
Because you do not own the policy, the death benefit is not included in your taxable estate.
Why the Trust Must Be Irrevocable
The key to keeping life insurance out of your estate is that the trust must be irrevocable. An irrevocable trust cannot be changed or canceled once it is created.
This is different from a revocable trust, which you can change or dissolve at any time.
The IRS requires the trust to be irrevocable because if you retain control over the policy, it will still be included in your estate.
That means:
- You cannot change the beneficiaries
- You cannot borrow against the policy
- You cannot cancel the policy
- You give up ownership permanently
This lack of control is what allows the policy to be excluded from your estate.
The Three-Year Rule
If you transfer an existing life insurance policy into an ILIT, the IRS has a special rule called the “three-year rule.”
Under IRC Section 2035, if you die within three years of transferring the policy, the death benefit is still included in your taxable estate.
This is why many people choose to have the ILIT purchase a new policy instead of transferring an existing one.
If the trust purchases the policy from the start, the three-year rule does not apply.
How Do You Pay Premiums on a Policy in an ILIT?
Once the policy is in the trust, you cannot pay the premiums directly (because that would mean you still have control).
Instead, you make annual gifts to the trust, and the trustee uses those gifts to pay the premiums.
To ensure these gifts qualify for the annual gift tax exclusion, the trust should include “Crummey powers.”
What Are Crummey Powers?
Crummey powers are a legal mechanism that allows your gifts to the trust to qualify for the annual gift tax exclusion.
Here is how it works:
- You make a gift to the trust (to pay the insurance premium)
- The trustee notifies the beneficiaries that they have a limited time (typically 30 days) to withdraw the gift
- If they do not withdraw it, the money stays in the trust and is used to pay the premium
This right of withdrawal makes the gift a “present interest” rather than a “future interest,” which qualifies it for the annual exclusion.
In 2026, the annual gift tax exclusion is $19,000 per person (or $38,000 for a married couple).
As long as your premium payments stay under this amount, you can fund the trust without using any of your lifetime gift tax exemption.
Can an ILIT Provide for Your Spouse?
Yes. An ILIT can be structured to provide for your surviving spouse while still keeping the death benefit out of your estate.
The trust can give the trustee discretion to:
- Make distributions to your spouse for living expenses, health care, or other needs
- Loan money to your spouse or your estate
- Purchase assets from your estate to provide liquidity
The trust can also be designed as a “spousal access trust,” which gives your spouse limited access to funds while maintaining the estate tax benefits.
Can You Change Beneficiaries in an ILIT?
No. Because the trust is irrevocable, you cannot change the beneficiaries once the trust is created.
This is why careful planning is essential. You need to think through:
- Who should benefit from the policy
- How the funds should be distributed
- What happens if a beneficiary dies before you
Some ILITs include provisions that give the trustee flexibility to adjust distributions based on changing circumstances, but the core beneficiaries cannot be changed.
Does Life Insurance in a Trust Avoid Probate?
Yes. Life insurance in a trust avoids probate.
When the trust owns the policy, the death benefit goes directly to the trust and is distributed according to the trust terms.
This is faster and more private than probate.
Even if you do not have estate tax concerns, using a trust for life insurance can still provide:
- Probate avoidance
- Privacy
- Control over how beneficiaries receive funds
- Protection from creditors
Is an ILIT Right for You?
You should consider an ILIT if:
- Your estate (including life insurance) exceeds the Massachusetts or federal estate tax exemption
- You want to remove life insurance from your taxable estate
- You want to provide liquidity to pay estate taxes
- You want to protect the death benefit from creditors and divorce
- You want to control how beneficiaries receive the funds
ILITs are most beneficial for high-net-worth families, but even moderate estates in Massachusetts can benefit due to the low state exemption.
Confused About Life Insurance and Estate Taxes? Let’s Talk
A poorly drafted ILIT can fail to achieve its purpose, or worse, create unintended tax consequences.
A well-designed ILIT can:
- Save your family hundreds of thousands (or millions) in estate taxes
- Provide liquidity when it is needed most
- Protect your legacy
- Give you peace of mind
Contact The Law Offices of Kimberly Butler Rainen today to schedule a consultation and begin building a plan that protects your family from unnecessary estate taxes.