We all know that life insurance can be an important part of our estate plans. It can provide immediate cash at the time of death to provide for our family’s needs – which for affluent families may include paying estate taxes.

Less well known, however, is why it may make sense for a high net worth individual to put a policy into a life insurance trust.

The proceeds of a life insurance policy are usually free of income tax to the beneficiary. But if the person who dies is the owner of the policy, those proceeds are part of his or her estate.

Two conditions must be met for the cash payout from a life insurance policy to be excluded from estate tax: the insured person must have no “incidents of ownership” over the policy, and the policy cannot be payable to his or her estate.

What that means is that you should not own or control the policy, and your estate should not be the beneficiary of the policy.

One way to ensure that you, as the insured person, do not have incidents of ownership over the policy is to create an irrevocable life insurance trust, or ILIT, to own the policy. With a properly structured ILIT, the death benefit paid to the trust is excluded from the gross estate of the insured, eliminating the liability for estate tax on the death benefit.

After you set up the irrevocable trust and place the life insurance policy in it, you no longer have “incidents of ownership” of the policy. That is, you don’t own or control it, and cannot borrow against it, assign it, cancel it or change the beneficiaries. As a result, it is not part of your estate.

Instead, when you form the ILIT you will name a trustee to manage the trust and, when the time comes, supervise the distribution of the trust assets – the life insurance proceeds – according to the terms of the trust document, which reflect your wishes as the grantor of the trust.

A life insurance trust also can provide important protection if the beneficiaries are embroiled in litigation, or become involved in a lawsuit in the future. That’s because the courts do not consider an ILIT to be an asset of the beneficiaries until such time as the insurance proceeds are paid to them. This makes it extremely unlikely that these assets can be seized by the courts or by creditors.

It’s important to plan carefully when setting up an ILIT. As the name states, it is irrevocable; you can’t change its terms later.

In addition, you cannot be the trustee yourself if you want to preserve the estate tax advantages. It may be possible for your spouse to be trustee under some circumstances, but a third party such as a trusted advisor, a bank, or a trust company is typically a better choice to ensure that the estate tax advantages are preserved. Banks or trust companies have the necessary financial expertise, cannot become sick or incapacitated, and are required to follow the directives you provide in the trust document.

You can provide funds to pay the premiums on the insurance policy by making annual tax-free gifts to the trustee on behalf of the trust beneficiaries. That’s currently $ 14,000 per beneficiary, or $ 28,000 if your spouse joins you in making these gifts.

The trustee will notify each beneficiary that the trust has received a gift on his or her behalf that will be used to pay the life insurance premiums unless the beneficiary elects to withdraw the gift immediately. The beneficiaries must understand, therefore, that they will be better off letting the money stay in the trust to pay the premiums.

While many people set up an ILIT when they are in their 50s or 60s, it’s important not to wait too long; with age there is a greater risk that you will be uninsurable.

You can transfer existing policies into the trust, but if you do not live for three more years after the transfer, the estate tax advantages will be lost and the insurance proceeds will be pulled back into your estate.

Properly set up and funded, an irrevocable life insurance trust may be a very effective way for individuals with significant assets to reduce estate taxes while providing added protection for family members.

Kelly S. Keuscher