Life Insurance is an investment. Like other investments, its value is included in the total value of an estate when an individual passes away. Where the value of an estate exceeds the available estate tax exemption (see below), the excess amount will be taxed at up to 45%!
Therefore, if an individual has a large life insurance policy, he or she may unwittingly cause a significant tax liability to his or her estate.
In order to avoid having one's estate pay unnecessary estate taxes, an "Irrevocable Life Insurance Trust", commonly known as an "ILIT" (pronounced "eyelet"), should be considered.
An ILIT is an irrevocable trust, which means that once it established, it cannot be undone (revoked). It must be established for the benefit of someone other than the trustor (the person creating it) or the trustor's spouse. Most often, the trustor's children are named as beneficiaries. During the trustor's lifetime, regular contributions may be made to the ILIT. The contributions will be used to pay for the life insurance policy which is owned by the trust. If structured properly, these contributions will be treated as gifts, but will not be subject to Gift Tax. Upon the trustor's death, the ILIT will be paid to the named beneficiaries, but will not be subject to any estate tax!
*The available estate tax exemption in 2009 is $3.5M. However, this exemption is currently scheduled to revert to $1M in 2011.
