Already Have Life Insurance? Why an ILIT May Be Worth It

Why It Matters

Using an ILIT can preserve wealth for heirs by shielding life‑insurance proceeds from both federal and state estate taxes, making it a critical tool for high‑net‑worth families.

Key Takeaways

• New York estate tax exemption is $7.35 million, lower than federal.
• Life‑insurance proceeds are includable in estate under IRC 2042.
• ILIT ownership removes incidents of ownership, excluding proceeds from estate.
• Transfers within three years trigger inclusion under IRC 2035.
• Buying policies directly in ILIT avoids the three‑year inclusion risk.

Pulse Analysis

State estate taxes are reshaping wealth transfer strategies, even for families that sit comfortably above the federal exemption of $15 million per individual. New York, for example, imposes a $7.35 million exemption and applies a harsh "cliff" rule: if the estate exceeds the threshold by more than 5 %, the entire estate becomes taxable. This creates a hidden liability for many high‑net‑worth individuals whose assets—real estate, retirement accounts, and investment portfolios—can quickly push them into the tax bracket, prompting a search for mitigation tools.

Life‑insurance policies, while often used to provide liquidity for heirs, can unintentionally increase estate tax exposure. Under Internal Revenue Code section 2042, death benefits are included in the decedent’s gross estate when the insured retains any ownership incidents, such as the ability to change beneficiaries or borrow against the policy. Consequently, a sizable policy can add millions of dollars to the taxable estate, eroding the very liquidity it was meant to supply. Understanding this interaction is essential for advisors who aim to preserve net wealth across generations.

An irrevocable life insurance trust (ILIT) offers a proven solution by holding the policy outside the insured’s estate, thereby eliminating ownership incidents. However, the three‑year look‑back rule in IRC section 2035 means that if the insured dies within three years of transferring an existing policy to the ILIT, the proceeds revert to the estate. To sidestep this risk, practitioners typically have the ILIT purchase new policies funded by contributions from the insured. This approach not only secures the tax‑free status of the death benefit but also aligns with broader estate‑tax planning objectives, making the ILIT a valuable component of sophisticated wealth‑preservation strategies.