FAQs — Life Insurance Trust

What is a Life Insurance Trust?

Many people have the incorrect impression that life insurance is "tax free." The assumption is incorrect. It is true that life insurance is income tax free, however, life insurance left to anyone other than a spouse is not exempt from estate tax. With the estate tax exemption set to return to $1 million in 2011, this is an important distinction, as individuals with insubstantial assets but more than $1 million in life insurance may be surprised to discover that 55% of their life insurance proceeds will be used to pay federal estate tax.

A Life Insurance Trust ("ILIT") is an estate tax savings device to address this problem. An ILIT is a form of an irrevocable trust that owns the life insurance policies on the life of the grantor and has complete control over the policies. The policies are transferred to the trust, or the trust purchases new life insurance on the life of the grantor. Occasionally, income-producing assets are placed in the trust to pay the premiums. Alternatively, with "whole" life insurance, the income generated by the whole life insurance policy is sufficient to pay future premiums. Another possibility is for the grantor to make annual gifts to the ILIT.

The grantor, who is usually also the insured, surrenders all ownership interest and control in the policies. When the grantor dies, the trust collects the insurance proceeds free of estate tax. Since the insurance is not payable to the estate, and the grantor did not "own" the policies at the time of his or her death and relinquished all rights in the policies, the proceeds of the life insurance policy are paid free of estate and income tax.