Avoiding the Three-Year Rule When Using an ILIT

With the lifetime estate and gift tax exemption at $13.99 million per person in 2025, most people needn't worry about federal estate taxes (assuming Congress extends the current exemption past the end of this year). However, estates that might exceed that amount should be aware of the IRS' three-year "clawback" rule, which mandates that any assets transferred out of your estate within three years of your death be counted as part of your estate for tax purposes.

"The IRS wants to prevent people from giving away assets at the last minute just to avoid paying estate taxes," says Austin Jarvis, director of estate, trust, and high-net-worth tax at the Schwab Center for Financial Research. "Limited exceptions to this rule exist, including gifts up to the annual exclusion—$19,000 per individual in 2025—as well as gifts to spouses."

In particular, people often inadvertently trigger the three-year clawback by gifting a life insurance policy to an irrevocable life insurance trust (ILIT), so as to remove the policy from their estate. "Say you paid $100,000 for a policy with a death benefit of $5 million," Austin says. "If you gift the policy to the ILIT and die within three years, all $5 million—not just the $100,000 premium—will be considered part of your estate."

To remove it from your estate and avoid the clawback, you need to sell the existing policy to the trust—not gift it. To do so, you would:

1. Work with an attorney to create and fund an ILIT to purchase the policy.
2. Request a policy valuation from your insurance company.
3. Use the ILIT to buy the policy, naming the trust as its new owner and sole beneficiary. The contents of the trust will eventually pass to the trust's beneficiaries; however, unlike the beneficiaries of the original life insurance policy, the trust's beneficiaries are irrevocable.

"Of course, you'd be better off using an ILIT to purchase a policy from the get-go," Austin says. "That way, it's never part of your estate, and you avoid the possibility of a clawback altogether."

Creating an ILIT can be complex and incur up-front as well as ongoing costs, so it's important to work with an estate attorney and a tax professional when considering this option.