Trusts are impressively flexible, offering many ways for people to use them. Revocable trusts can encompass many people's entire estate-planning needs in a single document. On the other hand, professionals have tailored some types of trusts to fit very specific situations and types of assets. The life insurance trust, primarily designed to hold life insurance policies, is a prime example.

Since they are irrevocable, life insurance trusts are often referred to as irrevocable life insurance trusts or ILITs. Holding life insurance in an ILIT, rather than owning it outright, can create huge estate-tax savings.

Current estate-tax rules apply to the death benefit of life insurance policies owned by your estate, even if someone outside the estate is named as their beneficiary. For large estates, a tax of 45% could apply to those policy proceeds, severely reducing the benefit of the insurance for your survivors. But if the life insurance is held within an appropriately drafted ILIT instead, the death benefit is exempt from current estate-tax rules.

To avoid these taxes, you must generally create an ILIT, deposit enough money in it to pay the premiums for the life insurance policy, then allow the ILIT to purchase the policy and become its owner. In order for this strategy to work, it's essential that the person covered by the policy (the insured) avoids having certain aspects of control over the ILIT.

Whether you use a large insurance company or a smaller firm, you should have little trouble working with your insurance agent or company representative to establish and maintain an ILIT. Some agents even have relationships with professionals who specialize in creating ILITs. (Of course, you should make sure that these people will represent your best interests, not the insurance company's.)

ILITs may include terms similar to those used in other trusts, but they tend to include substantial provisions specifically allowing the trustee to purchase life insurance. Because your intent in creating an ILIT counters the general rule that trustees should maintain diversified portfolios, the trust language must protect the trustee from any adverse consequences that could result from owning life insurance, rather than another type of asset.

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This article was originally published on June 13, 2006. It has been updated by Dan Caplinger. The Fool has a disclosure policy.