Can an ILIT be used for term life insurance as well as whole life policies

I recently met with Emily, a successful physician, who was devastated to learn her husband, David, had passed away unexpectedly. They had meticulously planned their estate, including a life insurance policy held outside of a properly funded Irrevocable Life Insurance Trust (ILIT). David had attempted to modify the trust to add the policy as a beneficiary using a hastily drafted codicil, but it wasn’t executed correctly. The result? Over $1.2 million in life insurance proceeds were subject to estate taxes, effectively reducing the inheritance for their children by almost half. This scenario is far too common, and easily avoidable with proactive planning.

What Types of Life Insurance Policies Work with an ILIT?

The short answer is yes, an ILIT can absolutely be used with term life insurance, and whole life insurance. Many people assume ILITs are solely for wealthy individuals with permanent policies, but that’s a misconception. In fact, for some clients, term life insurance held within an ILIT can be a remarkably effective strategy, especially when dealing with limited resources or specific financial goals. For over 35 years, I’ve guided clients through these complexities, leveraging my dual background as an Estate Planning Attorney and a CPA.

Why Consider an ILIT with Term Life Insurance?

While whole life policies build cash value, term life offers a lower premium for a specific period. An ILIT can still provide substantial estate tax savings even with a term policy. The key is timing and proper funding. The ILIT owns the policy, pays the premiums, and receives the death benefit free from estate taxes – regardless of whether the policy is term or whole. However, the challenges surrounding term life lie in its limited duration. If the insured outlives the term, the ILIT may need to be restructured, or a new policy secured, potentially at a higher premium due to age.

The Critical Role of Premium Payments and Crummey Letters

Regardless of the policy type, the ILIT must be properly funded. Simply establishing the trust isn’t enough. The trustee must make regular premium payments, and to qualify for the Annual Gift Tax Exclusion, the trustee must send ‘Crummey Letters’ to beneficiaries every time a deposit is made, granting them a temporary right to withdraw the funds (typically for 30 days). This allows the premiums to be considered gifts, shielding them from gift taxes, as outlined in IRC § 2503(b).

Avoiding Common Mistakes: Trustee Selection and Incidents of Ownership

One of the biggest mistakes I see is clients attempting to act as their own trustee. The grantor cannot serve as the trustee of their own ILIT; retaining any ‘incidents of ownership’ (like the power to change beneficiaries) under IRC § 2042 will cause the entire death benefit to be included in the taxable estate. An independent trustee – a trusted family member, a friend, or a corporate trustee – is essential. Furthermore, ensure the trustee has full access to policy information.

Digital Policy Access and RUFADAA

Increasingly, life insurance policies are managed online. Without specific RUFADAA language (Probate Code § 870) in the ILIT, service providers and insurers can legally block your trustee from accessing online policy portals to manage premiums or file claims. This can create significant administrative hurdles at a time when your family is already grieving. We routinely include this language in our ILITs to preemptively address this issue.

What Happens if Assets are Accidentally Left in the Grantor’s Name?

Occasionally, despite best intentions, cash assets intended for ILIT premium payments are legally left in the grantor’s name upon death, particularly if a premium is due shortly after. For deaths on or after April 1, 2025, if those assets are valued up to $750,000, they can potentially be transferred to the ILIT through a ‘Petition for Succession’ under AB 2016 (Probate Code § 13151). This is a Petition (Judge’s Order), not a Small Estate Affidavit, and allows the trustee to legally receive and use those funds for the benefit of the trust. It’s crucial to distinguish between these two processes.

Transferring Existing Policies (The “Clawback”)

If you’re transferring an existing life insurance policy into an ILIT, be aware of the potential “clawback” provision. Under IRC § 2035, if you pass away within 3 years of the transfer, the death benefit is “clawed back” into your taxable estate. To avoid this, the ILIT should purchase the policy directly from the start.

As a CPA as well as an attorney, I also guide clients on the step-up in basis and capital gains implications of life insurance, ensuring they maximize the financial benefits for their heirs.

How do California trustee duties and funding rules shape the outcome for beneficiaries?

Success in trust administration depends on more than just the document; it requires active management of assets, precise accounting to beneficiaries, and careful navigation of tax rules. Whether dealing with a blended family or complex real estate, understanding the mechanics of trust law is the only way to ensure the grantor’s wishes survive scrutiny.

To prevent family friction during administration, trustees must adhere to the rules in trust administration, while beneficiaries should monitor actions to prevent the issues highlighted in trustee errors, ensuring the trust document is enforced correctly.

Ultimately, the success of a trust depends on the details—proper funding, clear terms, and a trustee willing to follow the rules. By anticipating friction points and documenting every step of the administration, fiduciaries can protect the estate and themselves from liability.

Verified Authority on ILIT Administration & Tax Compliance

• The “3-Year Rule” (IRC § 2035): Internal Revenue Code § 2035
  The critical statute warning that transferring an existing policy to an ILIT triggers a 3-year waiting period. If the grantor dies within this window, the insurance proceeds are pulled back into the taxable estate.
• Incidents of Ownership (IRC § 2042): Internal Revenue Code § 2042
  This code section defines why a grantor cannot be the trustee. Retaining the power to change beneficiaries or borrow against the policy forces the death benefit into the gross estate for tax purposes.
• Annual Gift Exclusion (Crummey Powers): IRS Gift Tax Guidelines (IRC § 2503)
  The legal basis for “Crummey Letters.” Without these withdrawal notices, money contributed to the ILIT to pay premiums does not qualify for the annual gift tax exclusion and eats into the lifetime exemption.
• Estate Tax Exemption (OBBBA): IRS Estate Tax Guidelines
  Reflects the OBBBA permanent increase to a $15 million per person exemption (effective Jan 1, 2026). ILITs remain the primary vehicle for ensuring life insurance proceeds sit on top of this exemption rather than consuming it.
• Missed Asset Recovery (AB 2016): California Probate Code § 13151 (Petition for Succession)
  If “unspent premiums” or refund checks intended for the ILIT were accidentally left in the grantor’s name, this statute (effective April 1, 2025) allows for a “Petition for Succession” for assets up to $750,000, bypassing full probate.
• Digital Policy Access (RUFADAA): California Probate Code § 870 (RUFADAA)
  Without RUFADAA powers, a trustee may be unable to access online insurance dashboards to verify premium payments, potentially causing the policy to lapse.