In general, an Irrevocable Life Insurance Trust is any trust that is created by one person, for the benefit of the person’s heirs and then acts to distribute money after the person’s death. What makes an insurance trust different from other trusts is that it is designed to hold life insurance in a tax efficient manner making it very difficult to modify. The insured cannot be a beneficiary of this trust nor can the insured be a trustee. Also, while the trust can hold property other than life insurance, most people do not put much else into these trusts as the Grantor has very little control over the trust after it is established. Accordingly, the trust is not right for everyone.
The reason why so many financial experts recommend the Irrevocable Life Insurance Trust is because it is perhaps the single most tax efficient estate planning technique available to the general population. Many are under the false assumption that life insurance proceeds passes completely tax free to the beneficiary. While life insurance proceeds are paid out income tax free, it is subject to both the federal estate tax and the estate tax of most states. So, if a person owns a life insurance policy on his or her own life, then the face value of that policy will be includible in the person’s taxable estate.
There are two ways to avoid this tax, the first, and easiest way, is to have another person own the policy on your life. This works well for smaller policies and for when there is no danger that the new owner will modify beneficiaries in a manner that would displease the insured. For example, it would never be wise to have only one of three children own a policy on the parent when that new owner can easily change the beneficiary to himself. It would also not be wise for spouses to own large policies on each other because eventually both will die and then there will be a large tax. The second way to avoid the estate tax is to place the life insurance policy inside of a Life Insurance Trust. Because the policy is not owned by a person, it is not subject to either a federal or state estate tax. It is important to note that the transfer of an existing life insurance policy into the trust will result in a three year lookback for tax purposes. The easiest way to avoid the lookback period is to have the trust buy a new policy rather than transferring in an existing policy. For this reason, it is best to consult an experienced estate planning attorney before buying the life insurance policy.
The Irrevocable Life Insurance Trust is also frequently called a Life Insurance Trust or an ILIT. A life insurance trust that is designed to hold life insurance on the lives of both a husband and wife is known as a Second to Die Life Insurance Trust.