Irrevocable Life Insurance Trust
One way to remove life insurance proceeds from a taxable estate is to create an irrevocable life insurance trust (ILIT). An ILIT is an irrevocable trust created for the purpose of owning a life insurance policy. The insurance trust is a contract between a grantor and a trustee to administer an insurance contract for the benefit of the named beneficiaries. The trust cannot be rescinded, amended or modified in any way after it is created. Once the grantor contributes property to the trust, they cannot later reclaim ownership of the property or change the terms of the trust. Therefore, the proceeds are not included as part of the grantor's estate.

In many cases, it makes sense to find an outside source to be the trustee of an irrevocable life insurance trust. This could be a trust department at a local bank or financial institution but there may be additional costs involved. If an ILIT is properly structured, the death benefits paid to the trust will be free from inclusion in the gross estate of the insured. In addition, the ILIT can also be structured so that the trust will provide benefits to the insured's surviving spouse without inclusion in the surviving spouse's gross estate either.

Also, upon completion of the transfer, if the grantor or transferor dies within three years of the date from which the policy was transferred, the life insurance proceeds will be included in the grantor's estate for tax purposes. The beneficiary still receives the proceeds; however, the estate will have to report the proceeds when computing the estate tax. The three-year rule can be avoided if the life insurance policy is purchased at the outset by the trustee of the ILIT. This way there is no gift or transfer.

Estate and Gift Taxation

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