When Should I Consider A Life Insurance Trust?

A life insurance trust is a great way to avoid estate taxes on the proceeds from your life insurance policy. For most people, their life insurance proceeds will be included in their gross taxable estate when they die. The general rule is that life insurance proceeds will be included in the gross taxable estate if: (a) the named beneficiary is your estate or the executor of your Estate; (b) you possessed incidents of ownership at the time of your death (i.e., the ability to change beneficiaries or borrow against the policy); or (c) the ownership of the policy was transferred to someone else within three years of your death. And, for larger life insurance policies, those proceeds could subject your estate to federal and/or state estate taxes.

So, what do you do if you are planning on purchasing a life insurance policy with a large death benefit? Well, you might want to consider creating a irrevocable life insurance trust. The purpose of an irrevocable life insurance trust (sometimes called an ILIT) is to keep the policy proceeds out of your gross taxable estate and out of the estate of your spouse. This type of trust is typically created as a stand-alone trust. Its sole purpose is owning and holding your life insurance policy. Now, in order for the ILIT to effectively exclude the policy proceeds from your gross estate (a) you must not have any ownership rights in the policy; (b) your estate must not be named a beneficiary on the policy; and (c) you may not be a Trustee of the Trust (however, your spouse may act as a Trustee). The ILIT is a separate legal entity. The ILIT will have its own tax identification number. The ILIT will own the life insurance policy. The ILIT will receive the full proceeds which will be available to your heirs upon your death. This strategy also works for those who have an existing life insurance policy where the proceeds are currently includable in your gross tax estate. You can transfer your existing life insurance policy to an ILIT.

Besides avoiding estate taxes, an ILIT can be used to help pay your estate taxes. For many people, life insurance is a great way to help pay estate taxes. Let’s say your net worth is tied up in assets that cannot be easily liquidated, such as real estate or a small business. The life insurance death benefit provides the necessary liquidity so that your heirs do not have to sell the real estate or small business. However, if the life insurance policy is not held in a trust and passes through your estate, much of the benefit will be lost due to increased estate taxes. This strategy can be a great benefit and provide much needed liquidity to pay estate taxes without having your heirs have to worry about liquidating other assets to handle your estate.

Despite its great benefits, an ILIT does have some drawbacks. The trust itself and all transfers of life insurance policies into it are irrevocable. Since the trust is irrevocable, you get the estate tax benefits. But, it cannot be amended. This limitation will prevent you from changing beneficiaries or naming new beneficiaries. It also means you will be unable to borrow against the policy or cash it in. However, if you know that you will not change your beneficiaries and you know that you will not need to access the policy’s cash value during your life time, the Irrevocable Life Insurance Trust can be a great estate tax planning option.