NEW YORK (MarketWatch) - Life insurance is an important ingredient in making sure your family is taken care of after you die. While income tax does not apply to a life-insurance payout, the dreaded estate tax does.

If you have a substantial policy that could push the value of your estate above the tax threshold (currently $2 million) you can create an irrevocable life-insurance trust, a legal entity that will own the policy while you're alive and pay the proceeds to the beneficiaries you've designated after you die. A trust works with both cash-value (whole, universal) and term policies.

You'll need an experienced attorney to draw up the papers and you must convince the IRS you've given up ownership of the policy so you won't be able to alter its provisions, change who the beneficiaries are or pay the premiums yourself. (If that's giving up too much control you can give a policy outright to your children but if they're minors a trust probably makes more sense.)

There are other catches: the trust must be active three years before you die, so don't wait until to set one up. If you're transferring an existing policy you'll have to pay gift tax on its cash value so it's better to first set up a trust, which can then buy the policy.

If you know you're likely to face the estate tax anyway, your trust can buy a policy just to cover that expense so your heirs won't have to sell off securities, real estate or a family business at distressed prices to cover the estate-tax payments.

You'll want to name someone reliable and, in this case, perhaps 10 years younger than yourself, to act as trustee and also one or more backups.

At least one trustee (you can have more than one) should be independent - that is, not a spouse or child who is also a beneficiary. If your circumstances change - a new child or a divorce - a like-minded trustee should be able to change the trust structure according to your wishes.

To ensure that the premiums are paid, you deposit money annually in an account set up by the trustee.

Setting up an irrevocable life-insurance trust is complex so find an expert attorney and expect to pay $2,500 and up.

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By Marshall Loeb, MarketWatch

All contents © 2006 Daily News, L.P.