What is a Life Insurance Trust?

If you’ve done any research or reading on the topic of estate planning, you’ve probably heard the term “life insurance trust” or ILIT for short. Wondering what exactly this type of trust does? Life insurance proceeds are income tax-free, but not estate tax-free. They are includible in your taxable estate for determining federal estate tax.

The primary benefit of a life insurance trust is its ability to remove the insurance death benefit from your taxable estate. This means you minimize estate taxes and deliver the proceeds to your heirs both income tax-free and estate tax-free. Then 100% of the proceeds may be used to pay off the estate tax or distribute the proceeds to your heirs.

If you have a life insurance policy and the proceeds become part of your estate after you die, the result could be a very hefty tax bill because even though those proceeds are not subject to income tax, the estate tax is expected to return in 2011. And incidentally, the estate tax percentage has fluctuated throughout the years, going as high as 45% in the year 2007.

But if you allow a qualified estate planning attorney to set up an irrevocable life insurance trust, you can rest assured that the proceeds will be 100% tax-free, either to go to your beneficiaries or to be used to fund your tax liability.

Of course, certain guidelines must be met, and your estate attorney will know exactly what those are.

Some things to consider:

The insured must forfeit the right to change the beneficiary on the policy. That is because the beneficiary is, of course, the insurance trust itself. The insured does, however, still have the choice of who the beneficiaries are. However, the down side is if circumstances change, the beneficiaries are already permanently designated.

The insured cannot borrow money against the cash value of the policy. The reason for this is that if it took place, the insured is considered the policy owner. This means the proceeds would be pulled back into your taxable estate and therefore subject to the estate tax that was being avoided in the first place.

You cannot serve as the trustee of your own life insurance trust.

There are other considerations your estate attorney will explain to you as well, such as trust alternatives, payment of premiums to avoid gift tax, and different structures to suit your specific needs.