When you buy life insurance, you're providing financial security to your beneficiaries when you die. You also could inadvertently leave your loved ones with something else: a whopping tax bill.

Death benefits from life insurance policies are not subject to income tax, but they are subject to estate tax and inheritance tax. The federal estate tax will decrease and the levels of exempted assets will increase over the next few years. By 2010, the federal estate tax will disappear. In 2011, unless Congress takes action, the federal estate tax will return. Financial experts say that’s why precise planning is needed over the next several years — to ensure your heirs get the largest inheritance possible.

An irrevocable life insurance trust is a tool that can help beneficiaries erase the tax burden. The trust "owns" your life insurance policy, pays the premiums and awards the death benefit to your beneficiaries when you die. By placing ownership of the policy with a trust — not the insured — it removes the death benefit from your estate. If this drops your estate value below the exemption level (see chart), you've freed your beneficiaries from a big tax bill.

Insurance trusts sacrifice flexibility. Once you put your policy in the trust, it closes the door on many options you currently have.

Read my lips: No estate taxes

Attorneys, financial planners, estate planners and certified public accountants can draft trust documents. The cost to set up trusts ranges between $400 and $2,500, with the price depending on how many provisions you have in the trust. For example, some trusts are set up to allow offspring to take over as trustees at a certain age. Others set aside money to care for special-needs children. "There are a lot of complexities you can add once you get past the initial trust," says Dianne Reis, an attorney in Plano, Texas, who specializes in estate planning.

When you place your life insurance policy in the trust, you have to designate a trustee to manage it. The trustee can be a relative. You can also hire a trust management company, a bank, a lawyer or even an insurance company for an annual fee that can range from $500 to $1,200.

Many people who set up irrevocable life insurance trusts intend their beneficiaries to use death benefits to pay the taxes on a large estate. Set up properly, the trust can cover the tax bills of an estate.

Who should use a life insurance trust?

Irrevocable life insurance trusts are generally for the wealthy. If your estate is valued at less than the exemption level in place at the time of death, your beneficiaries can already receive your death benefit free of estate taxes.

Reis says many people won't bother with life insurance trusts unless their estates are worth $3 million or more. Also, estate taxes go up as the value of the estate increases, so there is a greater incentive for tax relief if your estate is worth more. On the other hand, many people don't like the inflexibility or hassle of having their life insurance policies in a trust, and don't want to pay someone to manage it.

Not a "Crummey" deal

Life insurance trusts can help you when you are alive, too. To make premium payments, you have to make cash payments or "gifts" to the trust. You can avoid paying gift taxes on amounts up to $12,000 if your policy is in a trust. This tax loophole is called "Crummey power." A man named Clifford Crummey created a trust to which he transferred his assets. His goal was to avoid estate and inheritance taxes when he died. In 1968, the Internal Revenue Service took Crummey to court, claiming he was using an illegal tax loophole. Crummey won and established a precedent, thus making the trust a legally acceptable tool.

Here's how it works: You write a check for up to $12,000 per beneficiary as a "gift" to the trust and give it to your trustee. Keeping the amount below $12,000 exempts it from the gift tax. The trustee then writes a letter to the beneficiaries, informing them they can withdraw the money from the trust in the next 30 days.

The goal is to not have the beneficiary withdraw the money.  In order to get the gift-tax break, however, the beneficiary must have the legal right to withdraw the money. "The tax law basically says, 'If you have the right to receive something, you've got it,'" says Norse Blazzard, an attorney in Fort Lauderdale, Fla., who specializes in insurance law.

If the beneficiaries do not withdraw the money, it then becomes property of the trust. In most cases, the trustee will send part of the money to the life insurance company to pay the life insurance premium. The rest will remain in the trust and go to your beneficiaries when you die.

Craig Hatcher, an estate planner in Modesto, Calif., says he tries to discourage beneficiaries from withdrawing the money. If a beneficiary withdraws the money that is supposed to pay premiums, there might not be enough cash left to make the payments. Hatcher says that means insurance policies could lapse and beneficiaries would not get the death benefit.

The responsibility of informing beneficiaries of their withdrawal rights is just one reason why it might be difficult to get relatives to act as your trustee. Blazzard says some trusts are created with a provision that the trustee dictates exactly how much each beneficiary gets — a decision many people feel should be made by a rational, objective person.

If a trustee skirts his responsibilities by consistently forgetting to notify beneficiaries of their withdrawal rights and failing to pay premiums on the policy, you can ask a judge to appoint another trustee. Trustees can also be sued for damages if they consistently fail to perform their duties. Reis says if a policy lapses because the trustee forgets to pay the premium, he can be sued for the amount of the death benefit. Insurance companies are diligent about notifying the trustee when premium payments are due, so he will have little excuse in court. "It would be one of the world's shortest cases," Hatcher says.

If you ever decide to cancel the life insurance policy within a trust, you can do so by ceasing gifts to the trust. That will stop premium payments and the policy will lapse. Hatcher says the insurance company can negotiate with the trustee to offer a "single premium" term life insurance policy in exchange for the cash value that has been built up in a whole life policy.

Look before you leap

Before you draft an irrevocable life insurance trust, examine the potential drawbacks:

• The trust is irrevocable, thus it is permanent. Once you decide to put your life insurance into a trust, there's no turning back the clock. You cannot take the policy out of the trust, although you can lapse or surrender it.

• You can't change the beneficiary of the policy. This could be particularly damaging to you if your family relationships change during the life of the policy.

• Death benefit is taxable for three years after transfer. If you transfer an existing life insurance policy to a trust but die within the next three years, the death benefit is still subject to estate taxes. To avoid this, you can have the trust purchase the policy from the start, so there is no transfer.

• No borrowing against your policy. If you want to take out a loan against your policy, forget it. You can't borrow against the cash value in the policy because you're no longer the policy's owner. The trustee can take out a loan, but if the loan benefits the insured in some way, the beneficiary could sue the trustee.

Remember, once you have a trust, you're committed to it. "You want to make sure you really want this life insurance policy for the rest of your life," says Reis. "Otherwise, it's not the plan for you."