If you are single and your net estate (including your life insurance) is more than the federal estate tax exemption ($1 million in 2013), or if you are married and your total net estate is more than two exemptions ($2 million in 2013), an irrevocable life insurance trust can reduce your estate taxes.
Remember, life insurance proceeds for which you have any "incidents of ownership" (policies you can borrow against, assign, or cancel, or for which you can revoke an assignment, or name or change the beneficiary) are included in your taxable estate when you die. And, in 2013, estate taxes go up to 55%.
Very simply, an irrevocable life insurance trust owns your insurance policies for you. And since you don't personally own the insurance, it will not be included in your taxable estate. So, your estate will pay less in estate taxes, and more of your estate will go to your family.
Of course, you could have another person (like your spouse or an adult child) own your insurance for you. That would also keep it out of your estate, but you would not have as much control over the policy. This person could change the beneficiary, take the cash value or even cancel the policy. With an irrevocable life insurance trust, the trustee you select (it must be someone other than you) must follow the instructions in your trust.
An irrevocable life insurance trust also gives you more control over how the proceeds are used. For example, you could direct the trustee to make the funds available to pay estate taxes and other final expenses. You could provide your surviving spouse with a lifetime income and keep the proceeds out of both your estates. You could also keep the proceeds in trust and provide periodic income to your children or other loved ones, without giving them the full amount.
Existing policies can be transferred into an irrevocable life insurance trust, but if you die within three years of making the transfer, the death benefits of the policies will be taxed as part of your estate. There may also be a gift tax.
The trustee can also purchase a new policy. But it must be done in a special way so you don't incur a gift tax. Currently, using annual tax-exempt gifts, you can give up to $12,000 ($24,000 if married) each year to one or more beneficiaries of the irrevocable life insurance trust. (The actual amount given will depend on the premium for the policy.) But instead of giving this money directly to the beneficiaries, you give it to the trustee for them.
The trustee then notifies each beneficiary that a gift has been received on his/her behalf and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds--by paying the premium on the insurance policy. Of course, for this to work, the beneficiaries must understand not to take the gift now. (By the way, the written notification to the beneficiaries is known as a "Crummey letter," named after the man who first tested it and had it approved by the IRS.