Life insurance is a key component of many estate plans as an income tax-advantaged source of additional liquidity. Life insurance proceeds are generally income tax free, leveraging the premium to provide your family with additional funds that can be used for several estate planning purposes. Life insurance proceeds can be subject to estate taxes. If the decedent owned a life insurance policy, the full amount of the death benefit will be included in their taxable estate regardless of the identity of the beneficiary.
Life insurance is often used to provide the liquidity to pay estate taxes, so it needs to be owned in a way that does not increase estate taxes. An irrevocable life insurance trust (ILIT) is an irrevocable trust that owns a life insurance policy (usually on the life of the grantor or the grantor and their spouse) that allows the death benefit to pass outside of their taxable estate. It both owns the policy and is the policy's beneficiary. The trust is structured so that its creation and funding do not create an estate tax issue.
People often underestimate the amount of an estate's expenses, including taxes. As a result, many estates lack the necessary liquidity to cover these expenses. Selling estate assets to provide cash for these expenses has income tax ramifications. The same is true for taking withdrawals from retirement accounts. An ILIT is a way to create additional liquidity on an income tax friendly basis without increasing the size of the taxable estate and the associated estate tax exposure.
Another benefit of using an ILIT is for estates that are illiquid or include assets, like farmland or a business, that the decedent wanted their family to retain. The cash provided by an ILIT allows these assets to be retained by the ILIT purchasing them from the estate and then distributing them to the beneficiaries. The estate then uses the cash to pay the estate taxes and other expenses.