ILITs Lessen Beneficiaries' Estate Tax Burden

An ILIT is not some new lamp designed by Apple.

An Irrevocable Life Insurance Trust is an estate planning tool that protects beneficiaries from being socked with taxes from a life insurance policy, whose proceeds, while exempt from federal income tax, are considered to be part of one’s taxable estate and subject to federal estate tax.

An ILIT, once established, is designed to hold life insurance policies whose ownership has been transferred to an ILIT trustee, such as a spouse or child. After setting up an ILIT, cash to make insurance policy premium payments are contributed to the trust. These contributions qualify for the annual gift tax exclusion and are exempt from a gift tax, and because the policy is now in a trust and you no longer own it, the proceeds cannot be taxed in your estate at the time of your death.

As the designated primary beneficiary of your life insurance policy, the ILIT holds the insurance proceeds at the time of death for the benefit of your spouse during his or her lifetime (the proceeds cannot be taxed in their estate either), after which the balance passes on to your children or other designated beneficiaries. An ILIT can also used with a second-to-die life insurance policy, which only pays out after both spouses have passed away.

Another key benefit of an ILIT is that it can provide your family with ready and accessible cash to pay estate taxes. It also protects the money from a beneficiary’s possibly spendthrift ways or creditors.

An ILIT is a tax strategy designed for wealthier families that stand to lose most should the estate tax exemption be repealed, as it could be on Jan. 1, 2013 in accordance with a law Congress signed in December 2010 that set an estate tax exemption at $5 million per person and a top tax rate of 35 percent for 2011 and 2012. Should Congress not take further action, the estate tax rate will revert to 55 percent.

There are drawbacks to an ILIT. An irrevocable trust means just that: it is permanent, and once you put your life insurance into a trust, it cannot be removed. You cannot change the beneficiary during the life of the policy, nor can you borrow against it (you are no longer the policy’s owner, remember).

It is recommended that a trust purchase a life insurance policy so there is no transfer. A policy’s death benefit is taxable for three years after a transfer, meaning that if you die within three years, the death benefit is subject to estate taxes.