How The Irrevocable Life Insurance Trust Saves Families From the Estate Tax Hammer

As I inch closer to death, I find myself thinking more about estate tax planning and the potentially massive tax bill my family might face if we’re extremely lucky. To get ahead of it, I dug into how an irrevocable life insurance trust (ILIT) could help families save big on the so-called death tax.

Picture this:

A couple in their late 70s, let’s call them the Yamamotos, spent their whole lives saving and investing. They built a thriving small business in Honolulu, bought a few rental properties, and squirreled away some stocks that did surprisingly well over the decades. By the time they’re both gone, their estate is worth about $50 million.

Sounds like the dream, right? Except there’s a nightmare twist: the IRS shows up with a 40% estate tax bill on everything above the exemption amount, which in 2025 is $13.99 million per individual, or $27.98 million for a married couple.

That means the Yamamotos’ estate owes roughly $8.8 million in taxes (40% of $22.02 million).

And here’s the problem: most of the Yamamotos’ wealth is tied up in their business and properties. The estate doesn’t have $9 million in liquid cash sitting around. To cover the bill, the executor may be forced into a fire sale, dumping assets below market value just to raise cash. Years of careful building and family legacy can get ripped apart in one swoop.

But there’s a better way. Instead of scrambling to liquidate assets under pressure, families can use life insurance to pay the bill. And not just any life insurance policy, but one wrapped neatly inside something called an Irrevocable Life Insurance Trust (ILIT).

Let me explain why this is one of the most underappreciated estate planning moves the wealthy can make.

Here’s the financial strategy: Instead of owning a life insurance policy in your own name, you create an ILIT and have the trust own the policy. When you pass away, the ILIT – not your estate – collects the tax-free death benefit. The ILIT can then provide liquidity to cover estate taxes or distribute what’s left to your heirs exactly as you instructed.

Why is this so powerful? Because any payout that goes into the ILIT is not counted as part of your taxable estate. Even if you have a giant estate and a giant life insurance payout, the IRS doesn’t get to double dip.

Let’s run some numbers:

Suppose our friend Mr. Yamamoto has a $10 million life insurance policy inside an ILIT. If he owned that policy himself, the payout would push his taxable estate up another $10 million. That’s another $4 million evaporating into taxes ($10 million X 40% death tax).

But with the ILIT in place? That same $10 million policy gets funneled into the trust, outside the IRS’s reach, and can be used to give the estate the liquidity it needs to pay the tax bill. The family keeps their real estate, their business, their investments, and avoids a panic fire sale. That’s a massive win.

An ILIT succeeds in removing the insurance from the estate. It does not deprive anybody of access to anything.

Flexibility: Beneficiaries, Trustees, and Even “Special Friends”

One of the great things about ILITs is flexibility. You can choose almost anyone as the beneficiary: kids, grandkids, business partners, even lifelong friends.

Historically, ILITs were also a discreet way to provide for unmarried partners or, let’s be honest, “special friends” outside of marriage. If an individual had a special friend they wanted to benefit for always being there for them physically and emotionally when their spouse was not, life insurance inside the trust was one way you could take care of that obligation.

Scandalous? Maybe. Practical? Definitely.

On a more traditional note, ILITs also let you add structure. Don’t want your grandkids blowing their inheritance on Bentleys and TikTok influencer gear? Fine. You can direct the trustee to release money only for college tuition or a down payment on a home.

You can also protect heirs from creditors, divorce disputes, and even their own bad decisions. Trust and life insurance laws are strong in most states, and combined together, they form a kind of legal shield.

Think of it as “money with seatbelts.”

How an ILIT Actually Works

The setup has to be precise to pass IRS scrutiny. That’s why you should speak to an estate planning lawyer to help you set it up. Here’s the playbook:

1. Create the ILIT – You (the grantor) set up the trust and name a trustee. This has to be “irrevocable” — meaning once it’s done, you can’t pull the money back out for yourself. A revocable living trust is one you can change.
2. ILIT Buys the Policy – Instead of you buying the life insurance policy, the trust buys and owns it. You fund the trust with cash so it can pay the premiums. Important: Don’t transfer an existing policy into the trust unless you’re sure you’ll live at least three more years. Otherwise, the IRS will pull it back into your taxable estate.
3. Notify Beneficiaries (Crummey Notices) – When you put money into the trust, beneficiaries technically have the right to withdraw it. The trustee has to send out “Crummey notices” (named after a taxpayer with great timing and a funny last name). Beneficiaries usually don’t take the money out, but the IRS requires this step for the trust to remain legit.
4. Trust Pays Premiums – After the notice period passes (usually 30–60 days), the trustee uses the cash to pay the policy premiums.
5. Death Benefit Provides Liquidity – When you pass away, the ILIT collects the death benefit. The trustee can then decide how to use the funds: provide liquidity to the estate to cover taxes, support heirs, or both.

For example, the ILIT might name your spouse as the primary beneficiary and your kids as secondary beneficiaries. That way, your spouse is taken care of, and whatever’s left passes to your children free of estate tax when your spouse later passes. Smart layering.

Pitfalls and Cautionary Tales

Like most good things in finance, ILITs come with caveats:

• Forget the Crummey notices and you’re toast. One lawyer recalled a client who tried to backdate notices using a laser printer, except the notices predated the invention of laser printers. The IRS wasn’t impressed. Result: the ILIT was voided, and the assets were dragged back into the taxable estate. Ouch.
• Watch out for oversized policies. Don’t let a life insurance salesman talk you into $40 million of coverage if your estate plan shows you only need $10 million. Permanent life insurance is expensive, and excess premiums can drain your liquidity.
• ILITs work best with permanent life insurance. Term life policies usually expire before estate taxes are due. But permanent policies (whole, universal, etc.) cost a hefty amount in premiums. You’ve got to weigh whether the coverage is worth it.
• Tax laws change. Today’s $13.99 million per-person exemption might not last, despite the passage of The One Big Beautiful Bill Act on July 4, 2025. If the exemption falls back to ~$5 million, many more families will be affected. Still, if your net worth is likely to grow, planning ahead with an ILIT can make sense.
• No take-backs. Once you lock money into an ILIT, it’s gone for good. Some families regret setting one up when times get tough later. Or perhaps you decide to aggressively decumulate wealth by YOLOing and giving enough away to charity that you end up way under the estate tax threshold when you die.

An ILIT Is Like A Pressure Release Valve

Estate taxes are often called the “rich person’s problem.” But here’s the reality: real estate appreciation, stock market gains, and business success can push families into taxable territory faster than they expect.

For the Yamamotos, sitting on a $50 million estate, the IRS’s cut is nearly $9 million. An ILIT is like a pressure valve. It takes the uncertainty and panic out of the equation by ensuring there’s cash available to pay Uncle Sam without dismantling the family legacy.

Is it perfect? No. It requires discipline, planning, and often some hefty life insurance premiums. But for families who want to avoid a forced fire sale and keep their wealth intact across generations, it’s one of the most practical estate planning tools out there.

As with all things money, the earlier you plan, the more options you have. Don’t wait until you’re 78 with your estate executor staring down the barrel of a multimillion-dollar tax bill. Talk to an estate attorney, run the numbers, and see if an ILIT fits into your plan.

Because if you don’t, the IRS might end up as your biggest heir, and they don’t even send thank-you notes.

Reader Question And Suggestions

Readers, do any of you have an ILIT set up inside an irrevocable trust? If so, how easy was it to create, and do you think it’ll be worth it? If you’re considering one, definitely consult an estate planning attorney, as I’m not one. At a minimum, make sure you’ve got a death file, a revocable living trust, or at least a will. Since death is inevitable, it’s on us to plan ahead so our heirs aren’t left scrambling once we’re gone.

You can check out Policygenius for a free, customized quote. My wife and I both used them to get matching 20-year term life insurance policies at an affordable price. The monthly premiums we pay are well worth it for the peace of mind alone. With two young children and a remaining mortgage, having life insurance is a non-negotiable part of our estate planning.