It is generally well known that life insurance proceeds, in most cases, pass to the named beneficiary free of any income tax.  Less well known, however, but vitally important, is that the payout from a life insurance policy is included in the "gross estate" of the policy owner for estate tax purposes at the policy owner's death and is potentially subject to estate taxes. If the owner's estate exceeds the level exempt from tax, a significant portion of the life insurance proceeds would then be payable to the Internal Revenue Service - instead of passing to the beneficiaries. 
 
An irrevocable life insurance trust ("ILIT") takes advantage of a purposeful loophole created by Congress. If an ILIT is created to own the life insurance policy and the proceeds of the life insurance policy are payable to the trustee of the ILIT upon the insured's death, then the proceeds are not included in the insured's estate and, therefore, are not taxable for federal estate tax purposes. This is true even though the insured gives the money to the trustee of the ILIT to pay the annual premiums of the life insurance policy.
 
The provisions of the ILIT can also provide liquidity for the estate of the insured. For example, the estate of the insured may consist of hard-to-sell assets such as real estate, an interest in a business venture, closely-held stock or valuable artwork, and there is no ready cash or marketable securities to pay the federal estate tax within nine months after the death of the insured, which is the deadline for paying federal estate tax. Therefore, the terms of the ILIT can provide that the trustee be allowed to purchase assets from the estate of the insured at the fair market value for those assets.
 
There are some drawbacks, however. Irrevocable is irrevocable. The person who created the ILIT cannot get the life insurance policy or the money given to pay the premiums from the trust for a financial emergency or because the creator later changes his or her mind. The insurance premiums that have been paid into the trust will not be available to the creator of the ILIT by means of borrowing against the policy's cash value. The creator of the ILIT can stop providing the funds to pay the annual premiums, but the creator of the trust cannot receive back what has already been paid into the trust.
 
The ILIT must also be carefully drafted so that it avoids any gift tax liability. Because the trust is irrevocable and because the trustee of the ILIT owns the policy, any funds transferred to the trustee of the ILIT to purchase the policy or to pay annual premiums are gifts for federal gift tax purposes. The $13,000 annual gift tax exclusion for an individual (or $26,000 if consented to by the individual's spouse) does not apply to gifts in trust because such gifts are a gift of a future interest and not a present interest. However, if the trust is drafted so as to allow the trust beneficiaries to have the power to receive the cash, rather than allowing the trustee of the ILIT to use the cash to pay for the insurance, then such power, called a "Crummey" power, will allow the gifts to the ILIT to qualify for the annual gift tax exclusion.
 
If the creator of an ILIT transfers an existing life insurance policy into an ILIT, three years must pass before the transfer of the life insurance policy becomes effective for estate tax purposes. Therefore, if the creator of the trust (who is also the insured) dies within three years of the transfer of the policy to the ILIT, the policy proceeds will be subject to federal estate tax in the estate of the creator of the ILIT.
 
An important consideration when creating an ILIT is determining who will be the trustee. The creator of the ILIT cannot also serve as the trustee because this would result in the creator of the trust having an incident of ownership in the life insurance policy and the policy proceeds would be taxed in the estate of the creator of the trust upon his or her death. Also, a beneficiary of an ILIT should not be a trustee. Therefore, you can choose a trusted professional advisor, friend or family member who is not a beneficiary or use a corporate fiduciary, such as a trust company or a bank's trust department. Charges for a corporate fiduciary vary according to the complexity of the trust but are typically an annual percentage of the trust assets.
 
ILITs are worth a careful look for anyone with a taxable estate, but are particularly appropriate for people who want to potentially leverage their annual gifts or who have large amounts of illiquid assets, such as real estate or a business that the family wants to continue to run. For those individuals with large existing life insurance policies, transferring such policies to an ILIT, subject to the three year rule, is a viable means to pass the life insurance policies to your loved ones free of estate tax.

Regardless of their level of personal wealth, there is one estate planning concern that is shared by people from all walks of life - the decision of who gets what when you are gone. While many people logically assume that a will is the official forum for expressing such decisions, that's not always the case. For instance, did you know that the proceeds from retirement plans, IRAs and life insurance policies are passed on independent of what may be spelled out in a will?
 
Naming beneficiaries to these types of accounts is one of those planning activities that is typically given too little thought, however those named to inherit such assets often face unique tax and legal consequences.
 
Employer-Sponsored Retirement Plans and Individual Retirement Accounts (IRAs)
 
Regarding employer-sponsored plans, such as 401(k)s, an individual who is not married can name whomever they like as beneficiary.  If you are married, however, federal law states that your spouse is automatically the beneficiary of a 401(k) or profit-sharing plan.  If you wish to name someone else as beneficiary, then your spouse must sign a written waiver.
 
For example, someone who has been separated from his or her spouse may wish to name a domestic partner as the intended beneficiary.  The spouse still has a legal claim to the 401(k) assets, and the domestic partner will not be able to receive the funds unless the spouse signs a written waiver.  A waiver may be appropriate in other situations, such as a second marriage in which children from the first marriage need the money more than the new spouse.
 
Until recently, one drawback was that non-spouse beneficiaries were not eligible for tax-deferred transfers to retirement plans.  Instead, these beneficiaries would have to begin taking distributions, on which they would be required to pay income tax.  However, rules signed into law in 2006 allow non-spousal beneficiaries to annuitize retirement plan distributions over the life of the beneficiary.  The IRS has also issued regulations that dramatically simplify the way certain withdrawals affect retirement plan owners and their beneficiaries.  Consult your tax advisor, employer and/or policy issuer on how these rule changes may affect your situation.
 
Life Insurance
 
No matter who is designated as beneficiary of a life insurance policy, he or she will receive the death benefit proceeds income tax-free.  Unlike property disposed of in a will, if the beneficiary designation form is properly completed, insurance proceeds do not go through probate.
 
For many married people, a spouse will be the most logical beneficiary. A trust may be a better beneficiary choice, however, if a surviving spouse was not capable of (or comfortable with) managing a large sum of money.  In this case, the trustee (often a legal entity rather than an individual) would take charge of managing, investing and disbursing the policy proceeds for the benefit of the surviving spouse.
 
Be sure to name contingent or secondary beneficiaries.  A secondary beneficiary - either an individual or trust - would be next in line to inherit the insurance proceeds if the primary beneficiary predeceases the insured.  If there are no surviving beneficiaries, then your beneficiary is generally the "estate of the insured," which means the death benefits end up being probated and ultimately distributed according to the instructions of the decedent's last will and testament.  If an individual dies without a valid will (intestate), then the order of legal beneficiaries to whom assets are distributed is specified by state law.
 
Avoid Naming Minor Children
 
Naming minor children as beneficiaries may cause unforeseen problems.  For example, insurance companies and retirement accounts may not pay death benefits to minors.  Instead, these benefits are held until they can be paid to a court-approved guardian and/or trustee of a child's trust or until the child reaches legal age.  A guardian, trust or trustee should be named beneficiary to ensure competent management of the proceeds for the children.  By naming a child's trust as a beneficiary, the proceeds could be invested and managed by a competent trustee (a person or institution) of your choosing.  A revocable living trust could also be named as a beneficiary, which keeps the proceeds out of probate.
 
Keep Your Plan Up-to-Date
 
When completing overall estate plans and wills, it is important to occasionally review and readjust all beneficiary designations so that your estate plan accurately reflects your wishes.  Remember, outdated beneficiary designations (e.g., older parents or ex-spouses) could misdirect the intended flow of an entire estate plan unless changed now.