Estate planning focuses on protecting both your assets and your beneficiaries. Placing life insurance in a trust can help support that goal.
Key considerations include understanding how life insurance trusts work, the differences between revocable and irrevocable trusts, and their potential benefits and drawbacks. It’s also important to determine whether this estate planning strategy fits your situation.
What Are Life Insurance Trusts?
Life insurance trusts are legal arrangements that hold a life insurance policy inside a trust. The trust controls how the death benefit is managed and distributed after the insured person dies. The goal of placing a policy in a trust is to help beneficiaries receive the proceeds in an organized way, reduce potential estate taxes, and follow the grantor’s wishes for how the money is used.
How Do Life Insurance Trusts Work?
A life insurance trust lets the policy owner, also called the grantor, transfer ownership of a life insurance policy into a trust. The trust helps manage life insurance benefits while addressing estate planning and tax considerations.
Below is a simplified overview of how a life insurance trust works.
- Trust creation: The grantor sets up an irrevocable trust and names the beneficiaries who will receive the life insurance benefit after the grantor’s death.
- Policy ownership: The trust purchases the life insurance policy with gifts from the grantor or the grantor transfers ownership of an existing life insurance policy to the trust. After the transfer, the grantor no longer owns the policy, and the trust becomes the policy owner.
- Trustee appointment: The grantor appoints a trustee to manage the trust. The trustee pays policy premiums, manages trust assets, and distributes the death benefit to beneficiaries.
- Premium payments: The grantor funds the trust with gifts to cover premium payments. The trustee uses these funds to pay the policy premiums.
- Estate tax benefit: Life insurance proceeds are generally excluded from the grantor’s taxable estate, which may help reduce estate taxes owed by beneficiaries.
What Are Some Types of Life Insurance Trusts?
Life insurance trusts are designed to meet different estate planning goals. The two primary types are irrevocable life insurance trusts and revocable life insurance trusts.
Irrevocable Life Insurance Trust (ILIT)
An irrevocable life insurance trust is the most common option. Once created, it cannot be changed. Its main purpose is to remove the life insurance proceeds from the insured's taxable estate, which may help reduce estate taxes. It also allows the grantor to control how and when beneficiaries receive the death benefit.
Revocable Life Insurance Trust (RLIT)
A revocable life insurance trust can be changed or revoked during the grantor’s lifetime.
An RLIT allows the grantor to keep control of the trust and the life insurance policies it holds. Changes can be made as circumstances evolve. Revocable trusts are commonly used in estate planning because they allow assets to pass to beneficiaries without going through probate, but trust assets are still included in the grantor’s estate for tax purposes.
Reasons to Fund a Trust With Life Insurance
Funding a trust with life insurance can support several estate planning goals. One key benefit is predictability. Life insurance is a contractual agreement. In exchange for premium payments, the insurer agrees to pay a death benefit when the insured dies. Guarantees are based on the claims paying ability of the insurer.
Additional reasons to fund a trust with life insurance include:
- Protection from the grantor’s creditors if the trust is irrevocable
- Financial support for beneficiaries
- Possible tax advantages
- Avoiding probate
Potential Estate Planning Benefits of a Life Insurance Trust
An irrevocable life insurance trust may help protect beneficiaries from creditors by shielding proceeds from certain claims. It can also provide ongoing financial support for family members or dependents after death.
Placing life insurance policies in a trust allows the grantor to control how and when proceeds are distributed. This can be helpful when beneficiaries are minors, lack financial experience, or need funds over time rather than in a lump sum.
If multiple life insurance policies exist, holding them within a single trust can simplify administration, improve coordination, and potentially reduce management fees.
Life insurance may also be used in charitable trusts. In this case, the trust receives the death benefit and directs the proceeds to charitable organizations.
Potential Tax Benefits of a Life Insurance Trust
Life insurance death benefits usually bypass probate because they are paid directly to named beneficiaries. However, the proceeds may still be included in an estate for tax purposes.
When life insurance policies are placed in an irrevocable trust, the proceeds are generally excluded from the insured’s taxable estate. This may reduce estate taxes for beneficiaries, especially for larger estates.
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What Are the Potential Drawbacks of a Life Insurance Trust?
A life insurance trust can be helpful in some estate plans, but it also comes with tradeoffs. Common drawbacks include the following:
- Cost: Setting up and maintaining a life insurance trust can be expensive. Legal fees are often required to create the trust and transfer the policy. Ongoing administrative fees may also apply.
- Complexity: Life insurance trusts can be complicated to set up and manage. The trust terms must align with your goals, the trust must be funded correctly, and premiums must be paid on time.
- Loss of control: Once a life insurance policy is transferred to an irrevocable trust, you give up control. You can no longer change beneficiaries, adjust coverage amounts, or modify the policy although your trustee may be able to do so.
- Tax implications: Using a life insurance trust can involve tax considerations. For example, if a policy is transferred to an irrevocable life insurance trust within three years of death, the death benefit may still be included in the grantor’s taxable estate.
- Risk of lapse: If premiums are not paid, the policy can lapse. If that happens, no death benefit would be paid to beneficiaries.
What to Consider Before Choosing a Life Insurance Trust
Before deciding whether a life insurance trust is right for you, consider the following factors:
- Your age and health: If you are older or in poor health, there is a higher chance of passing away within three years of transferring a policy to an ILIT. If that happens, the death benefit may still be subject to estate taxes.
- The size of your estate: Larger estates may see greater estate tax savings when using a life insurance trust.
- Your other assets: If you already have assets that are not subject to estate taxes, a life insurance trust may offer limited tax advantages.
- Your family situation: If you have minor children or dependents, a life insurance trust can help manage how and when proceeds are distributed in their best interests.
Ultimately, deciding whether to use a life insurance trust is a personal choice. Weigh the potential benefits and drawbacks carefully and discuss your options with an estate planning attorney.
The Bottom Line
Placing a life insurance policy in a trust can offer estate and tax advantages for you and your beneficiaries. Before setting one up, consider factors such as the type of trust, your beneficiaries’ financial needs, and applicable estate planning laws.
Because life insurance trusts involve legal and financial complexity and can affect your estate long term, professional guidance is recommended. Attorneys, accountants, and financial professionals can help provide confidence that the trust is set up correctly, aligns with your goals, and meets legal and tax requirements.
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Disclosures
- Estate tax treatment applies only to an irrevocable life insurance trust (ILIT). Life insurance held in a revocable trust is generally included in the insured’s taxable estate.
