While the benefits received from a life Insurance policy are not treated as income for tax purposes, if the life insurance policy was owned by the deceased within three years of his death, the estate of the deceased will be taxed on any amount of the insurance proceeds above the estate tax threshold. Okay, now in plain English. If you take out a life insurance policy on your own life, fund the policy during your life, and leave the proceeds to your spouse or other family member, they will owe big time taxes. So what can you do to avoid this?

Creating an Irrevocable Life Insurance Trust (or “ILIT”) will protect your family from the burden of estate taxes upon receiving the benefits of the life insurance policy. This estate tax savings can be accomplished either by the insured establishing an ILIT and giving existing life insurance policies to the trust, or by the trust itself purchasing a new policy on the insured’s life. The insurance will be excluded from the insured’s estate because the insured will not own the policy at the time of death.

There are three requirements: (1) the insured must not own or retain any incidents of ownership in the insurance, (2) the proceeds must be payable to the trust rather than the estate, and (3) if policies are given by the insured to the trust, the insured must survive the gift by 3 years. To avoid any gift tax consequence, simply borrow against the existing life insurance policy for the amount of equity/value already attained by the policy since instituting it.

An ILIT also provides the benefit of instructing who gets the money, at what age they get the money, and under what conditions they can get the money. For instance, you wouldn’t want your 7 year old to inherit $2 million in one lump sum. How much candy and video games do they actually need? Instead, the ILIT can name a trustee and pay for the needs of the child until the child reaches a suitable age for inheritance, such as 18, 21, or 25. You can see that your child is cared for but not given the opportunity to frivolously spend away the inheritance.