Most of my clients are surprised to learn that a life insurance policy can be one of the biggest, least-examined liabilities in their estate tax picture. The death benefit itself is usually income tax-free to your beneficiaries. But if you personally own the policy, its full face value is added right back into your taxable estate under federal law, and potentially into your New York taxable estate as well. A $3 million or $5 million policy purchased years ago to protect a young family can, decades later, become the very asset that pushes an estate over New York's estate tax exemption or eats into the federal exemption unnecessarily. An Irrevocable Life Insurance Trust, commonly called an ILIT, is the tool I use most often to solve this exact problem.
This article explains how life insurance ends up in your taxable estate in the first place, how an ILIT takes it back out, the three-year lookback rule that trips up families who transfer an existing policy instead of starting fresh, the Crummey notice procedure that makes annual premium gifts work, and how all of this fits together with New York's unique estate tax cliff. If you already have a general estate plan in place, this is a natural extension of it. If you do not, our estate planning practice can help you build the full picture around it.
Why Life Insurance Is Part of Your Taxable Estate
Under Internal Revenue Code Section 2042, the proceeds of a life insurance policy on your life are included in your gross estate for federal estate tax purposes if either of two things is true: the proceeds are payable to your estate, or you possessed any "incident of ownership" in the policy at the time of your death. Incidents of ownership are read broadly by the IRS. They include the right to change the beneficiary, the right to borrow against the cash value, the right to surrender or cancel the policy, the right to assign the policy, and even the right to select a settlement option. If you are the applicant and owner of your own policy, as most people are by default, you hold every one of these rights, and the entire death benefit is pulled into your estate regardless of who is named as beneficiary.
New York does not have a separate life insurance inclusion rule; it largely follows the federal gross estate calculation as the starting point for the New York taxable estate. That means an insurance policy you own is exposed on both the federal and New York sides at the same time. For a policy with a face value in the high six or seven figures, that exposure is not theoretical. It can be the deciding factor in whether an estate owes New York estate tax at all, a topic we cover in more depth in our article on how New York's estate tax actually works.
How an ILIT Removes the Proceeds From Your Estate
An ILIT is an irrevocable trust created specifically to own a life insurance policy on your life. Because the trust, not you, is the applicant, owner, and beneficiary of the policy, you personally hold no incidents of ownership at your death. The death benefit is paid to the trust rather than to your estate or to you directly, and it never appears on your estate tax return. The trustee then distributes or holds the proceeds according to the terms you set out in the trust document, which can mirror your overall estate plan: outright distributions to children, staggered distributions at certain ages, or continued trusts for a spouse or descendants.
The tradeoff for this tax result is irrevocability. Once the trust is created and the policy is transferred or purchased inside it, you give up the ability to change the beneficiary, borrow against the policy, or unwind the arrangement. This is a real decision, not a formality, and it is one reason I walk clients through the full range of alternatives, including the broader use of irrevocable trusts in New York, before recommending an ILIT specifically.
Key takeaway: An ILIT only works if you give up ownership and control of the policy completely. If you keep any string attached, such as the right to change the beneficiary or borrow against the cash value, the IRS will treat you as the owner and pull the proceeds back into your taxable estate.
The Three-Year Rule Under IRC Section 2035
One of the most common and most costly mistakes I see is a client transferring an existing life insurance policy into a newly formed ILIT and assuming the problem is solved immediately. It is not. IRC Section 2035 imposes a three-year lookback period on transfers of life insurance policies. If you already own a policy and you assign it to the ILIT, and you die within three years of that transfer, the full death benefit is added back into your gross estate exactly as if the transfer had never happened. The three-year clock only starts running on the date of the actual transfer, and there is no way to plan around it after the fact if you do not survive the period.
There is an important exception that changes the entire planning approach: the three-year rule applies to transfers of a policy you already own. It does not apply if the ILIT itself is the original applicant and owner of a brand-new policy from day one. In that structure, the trustee applies for the policy, the trust pays the premiums from the start, and you never personally hold an incident of ownership at any point. Because there is nothing to transfer, there is nothing for Section 2035 to reach back and undo.
This is why, whenever it is practical, I recommend that clients fund a new policy directly through the ILIT rather than moving an existing policy into one. When a client already owns a substantial existing policy and wants it inside an ILIT, we discuss the three-year exposure candidly, and in some cases a combination approach, such as replacing an older policy with new coverage purchased directly by the trust, is the more reliable path.
Crummey Withdrawal Powers and Funding the Trust
An ILIT does not pay premiums on its own; you fund it with cash gifts that the trustee then uses to pay the insurance company. The trouble is that a gift to an irrevocable trust is ordinarily treated as a gift of a future interest, which does not qualify for the annual gift tax exclusion, currently $19,000 per donor per recipient in 2025. Without more, every premium-funding gift would use up part of your lifetime federal gift and estate tax exemption.
The solution, well established since the 1968 Crummey v. Commissioner decision, is to give each trust beneficiary a temporary right to withdraw the contributed funds, usually for a window of 30 days after each gift. This withdrawal right converts the gift into a present interest gift eligible for the annual exclusion. In practice, this means that each time you make a contribution to the ILIT to cover an upcoming premium, the trustee must send a written Crummey notice to every beneficiary who holds a withdrawal right, informing them that a contribution has been made and that they may withdraw their share within the specified period. Beneficiaries are expected to let the withdrawal right lapse so the funds remain in trust to pay the premium, but the right has to be real and has to be properly documented.
This procedural discipline is not optional paperwork. If Crummey notices are inconsistent, undocumented, or never sent, the IRS can argue that the withdrawal rights were illusory and that the gifts do not qualify for the annual exclusion after all. I always set new ILIT clients up with a clear annual calendar for premium due dates and notice deadlines, and in many cases we or the trustee handle notice preparation directly so nothing is missed.
Providing Liquidity Without Forcing a Sale
Beyond keeping the death benefit out of your taxable estate, an ILIT solves a second, very practical problem: liquidity. Estate tax, whether federal, New York, or both, is generally due within nine months of death, in cash. Families whose wealth is concentrated in a closely held business, commercial real estate, or a single valuable residence often do not have nine months of tax due sitting in a bank account. Without a source of ready cash, the executor may be forced to sell a business at a discount, liquidate real estate in a hurry, or take on debt just to satisfy the tax bill.
Because ILIT proceeds are paid directly to the trust outside of probate and, when properly structured, outside the taxable estate, that cash is available almost immediately to the trustee. Many ILITs are drafted to permit the trustee to lend funds to the estate or to purchase assets from the estate at fair value, giving the estate the liquidity it needs without the insurance proceeds themselves becoming part of the taxable estate. This is a particularly important strategy for the business owners and real estate holders we work with through our high net worth estate planning practice, where a forced sale is often the single greatest risk to a family's legacy.
Choosing a Trustee for Your ILIT
The trustee of an ILIT has real, ongoing responsibilities: applying for or holding the policy, receiving contributions, sending Crummey notices on schedule, paying premiums on time, keeping the trust's books separate from personal funds, and eventually collecting and administering the death benefit. Some clients name an adult child or trusted relative as trustee, which keeps administration personal and often reduces cost. Others prefer a corporate trustee or professional fiduciary, particularly when the trust will hold a substantial policy, when beneficiaries do not get along, or when no family member is well suited to handle recurring administrative deadlines. Either way, the trustee cannot be you, and should generally not be someone whose interests would give the IRS grounds to argue that you retained indirect control over the policy.
Coordinating an ILIT With New York's Estate Tax Cliff
New York's estate tax rules make ILIT planning especially valuable for New York residents. The federal estate and gift tax exemption stands at $13.61 million per individual in 2025, and the One Big Beautiful Bill Act, signed into law in 2025, made a higher exemption amount permanent going forward, though clients should always confirm the current figures with us given how frequently federal tax law changes. New York's exemption is far smaller, approximately $7.16 million for 2025 and adjusted annually, and it comes with a feature the federal system does not have: the cliff. If a New York taxable estate exceeds the exemption amount by more than 5 percent, the exemption is lost entirely, and New York estate tax is calculated on the full value of the estate, not merely the amount over the exemption.
For an estate hovering near that New York threshold, an ILIT can be decisive. Removing a $1 million or $2 million life insurance policy from your gross estate can be the difference between an estate that comfortably fits under New York's exemption and one that falls off the cliff into a substantial New York estate tax bill. We walk through this cliff calculation with every client whose estate approaches the New York exemption amount, and we look at ILIT planning alongside other tools discussed in our wills and trusts practice to find the combination that fits your family and your assets.
The IRS publishes general guidance on how life insurance and other assets factor into the federal estate tax calculation, which you can review directly on the IRS estate tax page, though it does not address New York's separate rules or the specific mechanics of ILIT planning.
Is an ILIT Right for You?
An ILIT is not the right tool for every family. It makes the most sense when you own, or plan to purchase, a life insurance policy large enough that its inclusion in your taxable estate would meaningfully affect your federal or New York estate tax exposure, and when you are comfortable giving up control of that policy permanently in exchange for the tax benefit. For clients in that position, particularly those already near New York's exemption threshold or holding illiquid business or real estate assets, an ILIT is often one of the most cost-effective planning tools available, especially when the policy is purchased directly through the trust and the three-year rule is avoided altogether.
I have guided many New York families through exactly this analysis, weighing new coverage against existing policies, structuring Crummey notices correctly from the outset, and coordinating the trust with a broader estate plan. If you own a life insurance policy of significant value, or you are considering purchasing one, it is worth a conversation before any policy is applied for or transferred.
Frequently Asked Questions
Why is life insurance included in my taxable estate if the beneficiary receives it income tax-free?
Income tax and estate tax are separate systems. Life insurance proceeds generally pass to your named beneficiary free of income tax, but under IRC Section 2042, the death benefit is still added to your gross estate for estate tax purposes if you owned the policy or held any incident of ownership over it, such as the right to change beneficiaries, borrow against it, or cancel it. A $2 million policy you own can add $2 million to your taxable estate even though your family never pays income tax on the payout.
What is the three-year rule and how does it affect an existing life insurance policy?
IRC Section 2035 provides that if you transfer an existing life insurance policy into an ILIT and die within three years of the transfer, the full death benefit is pulled back into your taxable estate as though the transfer never happened. This rule only applies to policies you already own and then transfer. If the ILIT itself applies for and purchases a new policy on your life from the very beginning, with the trust as original applicant, owner, and beneficiary, the three-year rule generally does not apply because you never personally owned the policy.
What is a Crummey notice and why does my ILIT need one every time I make a gift?
Contributions to an irrevocable trust do not automatically qualify for the annual gift tax exclusion, which is $19,000 per donor per recipient in 2025, because gifts to a trust are usually gifts of a future interest. A Crummey withdrawal power gives each trust beneficiary a temporary, real right to withdraw the contributed funds, typically for 30 days. A Crummey notice is the formal letter that tells each beneficiary that a gift has been made and that the withdrawal window is open. Sending these notices is what converts an otherwise non-qualifying gift into a present interest gift eligible for the annual exclusion, letting you gift premium payments into the trust gift-tax-free within your annual limits.
How does an ILIT interact with New York's estate tax cliff?
New York has its own separate estate tax with an exemption of approximately $7.16 million for 2025, adjusted annually, well below the federal exemption. New York also applies a cliff: if a New York taxable estate exceeds the exemption amount by more than 5 percent, the exemption disappears entirely and the tax is calculated on the full estate value from dollar one, not just the excess. Because an ILIT removes the life insurance death benefit from your gross estate altogether, it can be the difference between staying safely under New York's exemption and falling off the cliff into a much larger New York estate tax bill.
Who should serve as trustee of my ILIT?
Many New York families name an adult child, a trusted relative, or a close friend as trustee, while others prefer a corporate trustee or a professional fiduciary, particularly for larger trusts or blended families. The trustee's duties are ongoing and specific: applying for or holding the policy, receiving premium gifts, sending timely Crummey notices to beneficiaries, maintaining records that support the trust's tax treatment, paying premiums on schedule, and eventually collecting and distributing the death benefit according to the trust terms. Whoever you choose needs to be reliable about deadlines and comfortable with basic trust administration, or willing to work closely with counsel who can guide the process.
