Life Insurance and Estate Taxes in 2026: When You Need an ILIT

The life insurance estate tax question catches a lot of families off guard. Your death benefit is income-tax-free to your beneficiaries, but if you own the policy, the full payout is counted as part of your taxable estate. For 2026 the federal exemption is $15 million per person, so most families owe nothing federally. New Yorkers face a much lower state threshold of $7.35 million, plus a “cliff” that can erase the exemption entirely.

If your net worth plus your death benefit lands anywhere near either line, an irrevocable life insurance trust (ILIT) keeps the payout outside your estate. Below I’ll show you how to run the numbers, when an ILIT is worth the paperwork, and the mistakes I see most often when clients set one up.

Is life insurance subject to estate tax?

Two different taxes get mixed up here, so let’s separate them.

Income tax. A death benefit paid because the insured died is generally excluded from the beneficiary’s gross income. The IRS says so plainly in Publication 559. Only the interest earned on a delayed payout is taxable.

Estate tax. This is where the surprise lives. When the IRS totals up what you owned at death, it includes life insurance on your life if the proceeds are payable to your estate, or if you held any “incidents of ownership” in the policy. The instructions for Form 706, Schedule D, spell out what counts: the right to change the beneficiary, to surrender or cancel the policy, to assign it, to borrow against it, or to pledge it for a loan.

In plain English: if you can change who gets the money, the IRS treats the whole death benefit as yours. A $3 million term policy adds $3 million to your estate, even though you never touched a dollar of it while alive.

The 2026 estate tax numbers that matter

Federal law changed in 2025. The One Big Beautiful Bill Act set the basic exclusion amount at $15 million per person for 2026 and removed the scheduled drop back to roughly half that. Inflation indexing resumes in 2027. The IRS confirmed the 2026 figure in its inflation-adjustment release, along with a $19,000 annual gift exclusion.

State law is the part most articles skip. New York does not follow the federal number. For deaths in 2026, the state’s basic exclusion amount is $7,350,000, and there is no portability between spouses.

2026 rule	Federal	New York State
Exemption per person	$15,000,000	$7,350,000
Married couple (with planning)	$30,000,000 via portability	No portability; each spouse must use their own
What happens just over the line	Only the excess is taxed	Excess taxed up to 105% of the exemption, then the cliff
The cliff	None	Above $7,717,500, the entire estate is taxable
Top rate	40%	16%
Life insurance you own	Included	Included

The New York cliff deserves a second look. Between $7,350,000 and $7,717,500, only the amount over the exemption is taxed. One dollar past $7,717,500 and the exemption disappears. Your estate is taxed on everything, not just the overage. A death benefit is often the item that pushes a family over that edge.

How to tell if your family has a problem

Here is the exercise I walk clients through. It takes ten minutes.

1. Add up everything you own: home equity, retirement accounts, brokerage and savings, business interests, and anything else of value.
2. Add the full death benefit of every life insurance policy you own on your own life, including group coverage through work.
3. Compare the total to $7,350,000 if you live in New York (or your own state’s threshold), and to $15,000,000 for federal purposes.

Take a Brooklyn couple in their late 40s. Home equity of $1.6 million, retirement accounts of $1.5 million, a brokerage account of $800,000, and a half interest in a family business worth $1.5 million. That is $5.4 million, comfortably under the New York line. Now add the $3 million term policy one spouse bought to protect the kids. The estate is $8.4 million, past the cliff. If that spouse dies and leaves the estate to the children, New York taxes the entire $8.4 million, not the overage.

Swap in a $2 million policy and the total is $7.4 million. That lands in the buffer zone, so only the $50,000 over the exemption is taxed. Same family, same house, very different bill. The difference is entirely the insurance, which is why the insurance is what we move.

These are rough illustrations. New York applies a rate table, and deductions change the result, so your CPA or estate attorney runs the real numbers. The point is that the death benefit belongs in the math from the start.

How an irrevocable life insurance trust works

An ILIT is a trust that owns the policy so you don’t. Because you hold no incidents of ownership, the death benefit is not part of your estate, federal or state. The proceeds land in the trust, and the trustee distributes them the way the trust document says.

The setup, step by step:

1. An estate attorney drafts the trust. You are the grantor. You name a trustee who is not you, often an adult child, a sibling, or a trust company, and you name the beneficiaries.
2. The trustee applies for the policy. The trust is the owner and the beneficiary from day one. You are only the insured. You still take the exam and answer the health questions.
3. You gift the premium to the trust each year. The trust has its own bank account. You write the check to the trust, never to the insurance company.
4. The trustee sends “Crummey” notices. Each beneficiary gets a letter giving them a short window, commonly 30 days, to withdraw their share of the gift. That withdrawal right is what turns your gift into a “present interest” so it qualifies for the $19,000 annual exclusion. Nobody is expected to withdraw, but the letters must actually go out.
5. The trustee pays the premium. After the window closes, the trustee pays the carrier from the trust account.
6. At death, the trust collects the payout. The trustee can distribute cash to your family, hold it for young children, or buy assets from your estate or lend it money so your executor can pay the tax without selling the business or the house.

That last step is the whole reason families use insurance this way. Estate taxes are due in cash, generally within nine months of death, and a trust holding an estate-free death benefit is the cleanest source of that cash.

The three-year rule: new policy vs. existing policy

If you already own a policy and transfer it to an ILIT, the IRS looks back three years. Die within three years of the transfer and the full death benefit comes right back into your estate under Internal Revenue Code section 2035. The Form 706 instructions require the executor to report it.

A brand-new policy applied for and issued to the trust never passes through your hands, so the three-year rule never applies. That is why I almost always recommend the trust buy a new policy rather than take over an old one, as long as your health still supports a good rate class.

Transferring an existing policy still makes sense when your health has changed and new coverage would be rated or declined, or when the old policy has guarantees you can’t replace. Either way, the transfer is a gift. A term policy has little gift value, but a permanent policy with cash value is valued using the carrier’s Form 712, and a large cash value can eat into your lifetime exemption.

One more wrinkle: if the policy you want to move is an old universal life contract that is now sending premium-increase notices, read my guide on universal life policies about to lapse first. Moving a struggling policy into a trust does not fix the policy.

Who actually needs an ILIT (and who doesn’t)

An ILIT costs real money to draft and requires annual upkeep. It is the right tool for some families and pointless for others.

Situation	ILIT worth it?	Why
New York family with $5M+ in assets plus a large policy	Usually yes	The state cliff turns a modest overage into a tax on everything
Business owner with an illiquid estate	Usually yes	Creates cash to pay tax and buy out heirs without a fire sale
Estate over $15M federally	Yes	Every dollar over the line faces a 40% top rate
Blended family or special-needs child	Often yes	The trust controls timing and protects benefits, regardless of taxes
Family well under state and federal thresholds	No	Simple beneficiary designations do the job for far less cost
Married couple planning to leave everything to each other	Maybe	The marital deduction defers the tax to the second death; it does not remove it

That last row is the misconception I correct most often. Leaving everything to your spouse creates no estate tax at the first death because of the unlimited marital deduction. But the survivor now owns everything, including the insurance proceeds, with only one New York exemption to shelter it. Couples in this position often do better with a survivorship (second-to-die) policy owned by an ILIT, which pays exactly when the tax comes due.

If taxes are not the driver, start with how much life insurance you actually need and keep the ownership simple.

Common ILIT mistakes I see

• Naming yourself trustee. Control is an incident of ownership. Pick someone else.
• Paying the carrier directly. Premiums must flow from you to the trust to the carrier. A personal check to the insurer can undo years of planning.
• Skipping the Crummey letters. No letters, no present interest, no annual exclusion. Those gifts then chip away at your lifetime exemption instead.
• Putting 20-year term in a permanent trust. If the estate tax need is lifelong, the policy has to be too. Use guaranteed universal life, whole life, or at minimum a convertible term policy. My comparison of term vs. whole life covers the trade-offs.
• Counting only the federal number. Plenty of New Yorkers relax because they are nowhere near $15 million, then get caught by $7.35 million.
• Business owners ignoring the Connelly decision. If your company owns life insurance to buy out a deceased partner, the 2024 Supreme Court ruling can raise the value of your shares for estate tax. My guide to key person and buy-sell life insurance explains the fix.

How I approach ILIT coverage as an independent broker

The trust is the attorney’s job. The policy inside it is mine. An ILIT policy usually has to last 40 or 50 years and never lapse, so I lean toward guaranteed universal life and survivorship products with strong no-lapse guarantees, and I compare them across 25+ carriers rather than defaulting to one company’s illustration.

Timing matters too. The trust needs its own tax ID and the trustee signs as owner, so the trust has to exist before the application goes in. I coordinate that with your attorney, which is what keeps the three-year rule out of the picture.

Estate liquidity is also only half of protection. If your income built this estate, a disability during your working years can drain it long before death does, so I look at term life and disability coverage alongside the ILIT policy. There are no broker fees for any of this. To see what a trust-owned policy would cost, request a quote and mention the ILIT so I quote the right products.

This article is general education, not tax or legal advice. Estate tax rules depend on your state, your marital status, and how your assets are titled. Work with an estate planning attorney and CPA before creating or funding a trust.

Life insurance estate tax FAQ

Is life insurance taxable to my beneficiaries?

Generally no. A death benefit paid because the insured died is excluded from the beneficiary’s income under federal law. Only interest paid on a delayed payout is taxable. Estate tax is a separate question that depends on who owned the policy.

Does life insurance count toward the estate tax exemption?

Yes, if you owned the policy or held any incidents of ownership, such as the right to change the beneficiary or borrow against it. The full death benefit is added to your gross estate. A policy owned by an ILIT from the start is not counted.

How much can I leave tax-free in 2026?

Federally, $15 million per person, or $30 million for a married couple using portability. New York’s 2026 exemption is $7.35 million per person with no portability. Other states have their own thresholds, and most states have no estate tax at all.

What is the New York estate tax cliff?

If a New York taxable estate exceeds 105% of the exemption ($7,717,500 for 2026), the exemption is lost entirely and the whole estate is taxed. Between $7,350,000 and $7,717,500, only the excess is taxed. A large death benefit is a common reason families cross that line.

Can I just name my spouse as beneficiary to avoid estate tax?

Naming your spouse avoids tax at the first death because of the unlimited marital deduction. It does not remove the tax. The surviving spouse now owns the proceeds, and everything is taxed at the second death with only one exemption. An ILIT, often with a survivorship policy, addresses that second death.

What is the three-year rule for life insurance?

If you transfer a policy you own to someone else, including an ILIT, and die within three years, the death benefit is pulled back into your estate. A new policy purchased directly by the trust avoids the rule because you never owned it.

What kind of policy should an ILIT own?

Because the estate tax need usually lasts a lifetime, the policy should too. Guaranteed universal life, whole life, and survivorship policies are common choices. Term can work for a temporary need or as a convertible placeholder, but a term policy that expires at 65 leaves the trust empty when the tax comes due.

Do I need an ILIT if my estate is under $15 million?

Federally, probably not. But if you live in New York or another state with its own estate tax, run the numbers against your state’s threshold with your insurance included. Many families under $15 million still have a state-level problem, and the trust is also useful for control and creditor protection regardless of taxes.