Reducing Estate Tax with an Irrevocable Life Insurance Trust (ILIT)
Published February 3, 2026
Life insurance can be a useful tool in the estate planning process. It can provide financial security to family, replace lost income, streamline business succession, secure long-term care protection, and provide liquidity in the estate administration process.
It’s easy to assume that invoking life insurance in an estate plan is straightforward, and it could be. After all every life insurance policy has a common anatomy: all life insurance policies have an owner (the individual who controls the policy), an insured (the individual whose life the policy insures) and a beneficiary (those who receive a benefit in the form of a payout upon the death of the insured).
However, many families encounter unexpected tax consequences tied to their life insurance policies, particularly in states like Massachusetts, where the estate tax threshold is low.
Taxation of Life Insurance
While the death benefit of a life insurance policy is generally not subject to income tax for beneficiaries, it is imperative for policyowners and life insurance professionals to understand that this does not mean life insurance is entirely “tax-free,” a commonly-cited misnomer. The ownership of life insurance can trigger significant estate tax liabilities, which can be a rude awakening for families.
With federal estate tax rates at 40% and Massachusetts estate tax rates reaching up to 16%, life insurance can create substantial estate tax issues. For wealthy individuals, a $1 million policy could result in a combined $560,000 tax burden factoring both the federal and Massachusetts estate tax hits. Although the federal estate tax exemption is currently $15 million for 2026 – thus, making it less of a concern for many – the Massachusetts estate tax exemption is only $2 million, making estate tax relevant even for middle-class families as this threshold is easily surpassed.
ILIT as a Tax Shelter
An Irrevocable Life Insurance Trust (ILIT) can serve as a protective measure against life insurance being included in your estate for tax purposes. Typically established as both the owner and beneficiary of a life insurance policy, the ILIT ensures that the policy is excluded from one’s estate. After death, the life insurance benefits can be utilized to achieve estate planning goals, such as providing for children or other beneficiaries, without incurring additional estate tax burdens.
Establishing an ILIT
There are two primary methods to fund an ILIT, depending on whether the ILIT will own a new life insurance policy or an existing life insurance policy:
Establishing a New Life Insurance Policy:
Establish ILIT.
Gift funds to the ILIT to purchase a life insurance policy.
Acquire a life insurance policy, naming the ILIT as both owner and beneficiary.
This method is generally the most advisable, as you will not hold any personal ownership over the policy.
Transferring an Existing Policy:
Establish ILIT.
Transfer ownership of an existing life insurance policy into the ILIT.
This transfer constitutes a gift, potentially triggering gift tax consequences. However, the taxable amount is based on the fair market value of the policy at the time of transfer—not the death benefit. Although the gift tax implications may be minimal, caution is necessary. If you pass away within three years of transferring the policy to the ILIT, it will still be included in your estate.
Administering an ILIT
When an ILIT holds a life insurance policy, premium payments must be properly managed. This typically involves making cash gifts to the ILIT, enabling the ILIT to cover these premiums. While these cash transfers qualify as gifts for tax purposes, they may be exempt from gift tax if specific notices are provided to the trust beneficiaries. Accordingly, once established, an ILIT requires some ongoing administration.
It is also crucial to avoid retaining any “incidents of ownership,” as defined by the Tax Code. Such incidents include the ability to change beneficiaries or cancel the policy. Retaining any of these powers can lead to the inclusion of the life insurance policy in your estate, nullifying the ILIT’s protective benefits. Therefore, it is vital to structure both the trust document and life insurance policy in accordance with IRS regulations.
Closing Thoughts About ILITs
“Life insurance is tax-free” is one of the biggest misnomers we hear in estate planning. That’s because life insurance proceeds are typically includable in the policyholder’s estate. Incorporating an ILIT into your estate plan, however, can defend against this estate tax inclusion. Careful planning and strict compliance with IRS regulations are imperative.
Ready to explore how an ILIT can enhance your estate plan?
Contact Old Colony Law today to schedule a consultation, about your estate planning or whether an ILIT is advisable in your situation.