How does a life insurance trust work?

This type of insurance is also called an Irrevocable Life Insurance Trust (ILIT). It is used to transfer the life insurance proceeds into a trust that redistributes them to heirs when the policy is paid. The primary importance of using a life insurance trust is to prevent the life insurance proceeds from becoming part of the estate and taxed accordingly.

The originator of the life insurance trust establishes a donor-based trust, and then transfers the beneficiary of the life insurance policy to the trust. The person then makes annual or semi-annual deposits into the life insurance trust to cover the premiums. When the originator dies, the life insurance policy is paid to the trust instead of the heirs of the estate, and the proceeds are then redistributed to the designated heirs. In effect, the trust administers the distribution of the life insurance policy.

Using an ILIT helps the insured party pass on more of the value of the will to their heirs, or allows redistribution of estate property and finances to other institutions without taxation. One example of this might be using the fund to establish a yearly grant for a particular educational purpose or to a favored charitable organization. Keep in mind, too, that if the estate is equal to or less than the taxable estate limits set by law, the use of ILIT serves little purpose and could be avoided completely.