Using an IRA to Fund a Life Insurance Trust

A traditional IRA is one of the most tax-exposed assets in an estate. Not only must the account owner take taxable required minimum distributions (RMDs) starting at 73 or 75 (depending on birth year), but any remaining balance after death forms part of their taxable estate—leaving heirs to pay taxes on all withdrawals.

To blunt the tax hit, some IRA owners take distributions to fund an irrevocable life insurance trust (ILIT), which can potentially shield assets from estate taxes, reduce future income taxes, and provide greater control over how an estate is distributed.

Unlike assets such as real estate or stocks, an inherited traditional IRA doesn't receive a step-up in cost basis, which adjusts the value of an inherited asset to its fair market value at the time of the original owner's death rather than the price they originally paid. Therefore, its taxable value includes the principal plus any gains—and every dollar withdrawn from the account by a beneficiary is taxed as ordinary income.

What's more, most nonspousal adult beneficiaries must deplete inherited IRA balances within 10 years. As a result, sizable accounts could require distributions so large that they push heirs into a higher tax bracket, further diminishing the net value of their inheritance. (Individuals who are chronically ill, disabled, or not more than 10 years younger than the deceased are exempt from this rule; minors have 10 years after they turn 21 to liquidate any remaining assets.) 

With an ILIT, the trust uses IRA distributions to purchase a life insurance policy that, upon your death, gives beneficiaries a tax-free payout that is excluded from your estate. Furthermore, the withdrawals themselves can help reduce your IRA balance and therefore your future RMDs, providing greater control over your taxable income in retirement.

The strategy is best implemented after age 59½ to avoid paying early-withdrawal penalties, though how you decide to fund the trust may depend on your current tax situation. For example:

• If you're in a lower bracket, it might make sense to take smaller withdrawals and pay the life insurance premiums annually to avoid potentially bumping yourself into a higher tax bracket with a one-time premium distribution.
• If you're regularly in the highest income tax bracket, on the other hand, you might consider taking a large withdrawal from your IRA to fund the ILIT in one lump sum, since there's no tax benefit to spreading out the withdrawals over time.

When choosing the life insurance policy, carrier selection is critical. Options can vary significantly among insurance providers depending on your age and health status. Ideally, you should look for a standard permanent policy that has a high death benefit but a low cash value, since your goal is not to borrow against the value of your policy but rather yield the maximum payout to your heirs.

Using an ILIT in this way is not suitable for everyone. First, ask yourself:

• Can I afford to part with these funds? Because the terms of an ILIT are irrevocable—meaning generally they cannot be changed—even investors with large IRAs need to understand that these funds will not be accessible during retirement and should be earmarked for legacy purposes.
• Do I have any age- or health-related conditions? Because premium costs depend on factors like your age and health, life insurance becomes increasingly expensive as you get older. Therefore, it's best to apply sooner rather than later to obtain the best possible rate.
• Do I have any qualified beneficiaries? Certain qualified beneficiaries, such as those with special needs, are exempt from the 10-year rule for inherited IRA distributions and can stretch their withdrawals over a lifetime, largely obviating the need for an ILIT.
• Could my estate be taxed? Those whose estate values may exceed the federal lifetime exemption limit ($15 million for individuals and $30 million for married couples in 2026) might consider an ILIT to shield an insurance policy's death benefit from being included in their taxable estate.
• Do I want control over my policy's payout? Without a trust in place, the death benefit from a life insurance policy pays directly to heirs for them to manage as they see fit. With an ILIT, the trust can oversee future distributions, ensuring that the funds are used according to the wishes of the trust's creator.

To keep the insurance death benefit outside of your estate, you must file a gift tax return (IRS Form 709) if your gift of premiums to the ILIT exceeds the annual exclusion of $19,000 per person, per recipient in 2026. (If you're married and execute a split gift—in which a married couple treats a gift made by one spouse as if it were split between both spouses—you'll need to file a gift tax return even if your giving falls short of the annual exclusion.)

Additionally, establishing and maintaining an ILIT can incur high administrative fees, so make sure the numbers work before you commit to this or any other trust strategy.