Irrevocable Life Insurance Trust

Generally, the proceeds from any life insurance policies owned by you and which insure your life are included in your estate for estate (death) tax purposes.  In other words, if a policy pays $1,000,000 at your death to you, your estate, your spouse or any other person, your estate will be responsible for paying any estate taxes owed on this sum (Estate taxes are currently 45% of total assets in excess of $2,000,000.)  Assuming other assets in your estate are worth $2,000,000 or more, estate taxes on a $1,000,000 life policy would be $450,000.  An irrevocable life insurance trust (ILIT) can avoid this tax bill and provide an extra $450,000 to your heirs. 

First, an irrevocable (noncancelable) trust is created.  Thereafter, it may either purchase insurance on your life or you may transfer an existing policy into the trust.  The former method is preferable because if you transfer an existing policy into the trust, it will not achieve the tax savings benefit until after the passage of three years.  If you pass within that period, the IRS can deem the death benefits to be part of your estate and subject to estate taxes.  During the existence of the trust, the premiums on the policy may be paid by you in a manner that avoids gift taxes by use of the annual gift tax exclusion (currently $12,000 per year).  When you pass, the death benefits will go to your heirs (e.g., spouse or children) estate tax-free because the trust owns the insurance, not you.  Your heirs will not owe any income taxes on the death benefits either.

People also use life insurance trusts for non-tax purposes:

  § To provide liquidity for an estate.  For estates (e.g., comprised primarily of a business or undeveloped real estate) without sufficient liquid assets to pay estate taxes or other debt, a life insurance trust will be beneficial.  The cash from the trust will allow the beneficiary to avoid having to sell the assets or pledge them as security for a loan in order to pay taxes or debts;

  § To replace assets given to a charity.  Life insurance trusts are often used by people who make gifts to charities in order to replace money that would otherwise go to their heirs;

  § To increase the size of an estate.  People invest money by buying a life insurance policy which pays death benefits to the insured's family.