What Is a Life Insurance Trust?

The essence of estate planning is protecting your beneficiaries and your assets at the same time. Life insurance in a trust can work as a strategy to help accomplish this important life goal.

Here are some of the considerations around placing life insurance in a trust. They include knowing the difference between an irrevocable and a revocable life insurance trust, understanding how life insurance trusts work, weighing the potential benefits and drawbacks and evaluating whether this estate planning strategy may suit you.

What Are Life Insurance Trusts?

Life insurance trusts are legal arrangements for placing a life insurance policy within a trust in order to manage and distribute the policy's death benefit. The primary objective of a life insurance policy in a trust is to provide a means for beneficiaries to receive life insurance benefits while helping minimize potential estate taxes as well as helping ensure the proceeds are managed per the grantor's wishes.

How Do Life Insurance Trusts Work?

Life insurance trusts allow the owner of a life insurance policy (the grantor) to transfer ownership of the policy into a trust. A life insurance trust serves to help preserve and manage life insurance benefits while addressing estate planning and tax considerations.

Here's a simplified overview of how a life insurance trust works:

• Trust creation: The grantor establishes an irrevocable trust and designates beneficiaries who will receive the life insurance benefit when the grantor dies.
• Policy transfer: The grantor transfers ownership of an existing life insurance policy into the trust. Once transferred, the grantor no longer owns the policy and the trust becomes the owner.
• Trustee appointment: The grantor appoints a trustee to manage the trust. The trustee's role includes ensuring that policy premiums are paid, managing the trust's assets and distributing the policy's death benefit to beneficiaries.
• Premium payments: The trust is funded by the grantor, who contributes money to cover the life insurance policy's premium payments. The trustee uses this money to pay the premiums.
• Estate tax benefit: The life insurance proceeds are typically excluded from the grantor's taxable estate, potentially reducing estate taxes that beneficiaries would owe.
• Beneficiary distribution: Upon the grantor's death, the life insurance proceeds are paid to the trust. The trustee follows the instructions in the trust document to distribute the funds to the designated beneficiaries.

What Are Some Types of Life Insurance Trusts?

Multiple types of life insurance trusts serve different purposes and address specific estate planning goals. The main types of life insurance trusts are irrevocable life insurance trusts and revocable life insurance trusts.

Irrevocable Life Insurance Trust (ILIT)

An irrevocable life insurance trust is the most common type. ("Irrevocable" means the trust can't be changed.) An ILIT is established for one or more life insurance policies. The main objective: to exclude the life insurance proceeds from the insured's taxable estate, potentially reducing estate taxes. The trust can also help provide control over how the insurance benefit is distributed to beneficiaries.

Revocable Life Insurance Trust (RLIT)

A revocable life insurance trust is one set up to hold life insurance policies while maintaining the revocable nature of the trust. ("Revocable," the opposite of irrevocable, means the trust can be changed.) An RLIT allows the grantor to retain control over the trust during their lifetime, making changes or revoking the trust as needed. Revocable trusts are often used for estate planning, allowing assets to transfer to beneficiaries without going through probate.

Reasons to Fund a Trust With Life Insurance

Funding a trust with life insurance can serve various estate planning needs. First and foremost is the measure of certainty it offers. Life insurance represents a contractual promise. In exchange for premium payments, the insurer will, per the contract, pay a death benefit upon the death of the insured person. (As always, guarantees are based on the claims-paying ability of the insurer, which has sole financial responsibility for its products.)

Other important reasons to fund a trust with life insurance include protection from creditors, providing for beneficiaries, possible tax advantages and bypassing probate.

Potential Estate Planning Benefits of a Life Insurance Trust

A trust can help provide creditor protection for the policy's beneficiaries. It may help shield the life insurance proceeds from potential claims or creditors. Life insurance policies can also provide a source of financial support for beneficiaries, such as family members or dependents, after your death. Placing the policy or policies in a trust helps ensure proper management and distribution of these funds according to the grantor's wishes.

Trusts allow grantors to dictate how and when the life insurance proceeds will be distributed to beneficiaries. This control can be particularly useful when beneficiaries are minors, financially inexperienced or need to receive funds over time. When multiple life insurance policies are involved, consolidating them within a trust can simplify administration, ensure coordinated management and potentially reduce fees associated with maintaining multiple individual policies.

A charitable trust may also use life insurance policies to benefit charitable organizations. The trust can receive the life insurance proceeds upon the insured's death, and the beneficiaries can be charitable causes.

Potential Tax Benefits of a Life Insurance Trust

Although life insurance death benefits typically bypass probate because they go directly to named beneficiaries when you die, life insurance proceeds may be considered part of an estate for tax purposes. However, by placing life insurance policies within an irrevocable trust, the policy proceeds are excluded from the insured's taxable estate. That potentially reduces estate taxes for beneficiaries. The savings can be significant, especially if your estate is large.

What Are the Potential Drawbacks of a Life Insurance Trust?

There may be potential drawbacks to using a life insurance trust. Some of the common include:

• Cost: Setting up and maintaining a life insurance trust can be expensive. You will likely need to pay legal fees to create the trust and to transfer the life insurance policy to the trust. You may also need to pay annual administrative fees to maintain the trust.
• Complexity: Life insurance trusts can be complex to set up and manage. You will need to carefully consider the terms of the trust and make sure that they are consistent with your goals. You should also make sure that the trust is properly funded and that the premiums are paid on time.
• Loss of control: Once you transfer a life insurance policy to an irrevocable trust, you lose control over the policy. You will no longer be able to make changes to the policy, such as changing the beneficiary or increasing the coverage.
• Tax implications: Certain tax implications accompany the use a life insurance trust. For example, if you transfer a policy to an ILIT within three years of death, the death benefit may be subject to estate taxes.
• Risk of lapse: If you don't pay the premiums, the life insurance policy could lapse. That would mean no death benefit would be paid out to the beneficiaries.

What to Consider Before Choosing a Life Insurance Trust

Here are some additional things to consider when deciding whether or not to use a life insurance trust:

• Your age and health: If you are older or in poor health, you may be more likely to die within three years of transferring the policy to an ILIT. This could result in the death benefit being subject to estate taxes.
• The size of your estate: If your estate is large, you may be able to save a significant amount of estate taxes by using a life insurance trust.
• Your other assets: If you have other assets that are not subject to estate taxes, you may not need to use a life insurance trust to avoid estate taxes.
• Your family situation: If you have minor children or other dependents, you may want to use a life insurance trust to ensure that they receive the proceeds in a way that is in their best interests.

Ultimately, the decision of whether or not to use a life insurance trust is a personal one. You should weigh the potential benefits and drawbacks carefully and discuss your options with an estate planning attorney.

Frequently Asked Questions (FAQ)

What is the purpose of a life insurance trust?

The purpose of a life insurance trust is to provide a strategic framework for managing life insurance policies and their proceeds to achieve specific estate planning goals, help minimize tax implications and help ensure that the intended beneficiaries receive financial support in accordance with the grantor's wishes.

When should you put life insurance in a trust?

Deciding when to put life insurance in a trust depends on your specific estate planning goals, financial situation and personal circumstances. Timing is also important, as there may be a waiting period (typically two to three years) to ensure that the policy is fully outside of your estate for estate tax purposes.

Can you take money out of a life insurance trust?

Taking money out of a life insurance trust involves several considerations and depends on the terms of the trust, the type of trust and the purpose for which the trust was established. For example, the trust might allow for distributions to beneficiaries upon reaching a certain age, achieving specific milestones or for specific financial needs. Irrevocable trusts, commonly used for estate planning and tax benefits, generally have stricter rules regarding withdrawals compared to revocable trusts.

How do you set up a life insurance trust?

The basic steps in setting up a life insurance trust are to choose a trustee, create the trust document, transfer the life insurance policy to the trust and fund the trust with assets.

• Choose a trustee: The trustee is the person or entity who will manage the trust and distribute the proceeds to the beneficiaries. You may choose a family member, friend or professional trustee.
• Create the trust document: The trust document is a legal document that specifies the terms of the trust, such as who the beneficiaries are, how the proceeds will be distributed and what happens if the trustee dies or becomes incapacitated. You should have the trust document drafted by an estate planning attorney.
• Transfer the life insurance policy to the trust: You will need to sign a transfer of ownership form and provide the insurance company with the name of the trust as the new owner of the policy.
• Fund the trust: You can fund the trust by transferring assets to the trust, such as cash, stocks, or bonds. You can also fund the trust by making annual premium payments on the life insurance policy.

Are there alternatives to a life insurance trust?

There are some alternatives to a life insurance trust. They include owning the policy in your own name and naming the trust as the beneficiary, using a living trust, purchasing a second-to-die life insurance policy or using a gifting strategy.

• Own the policy in your own name and name a trust as the beneficiary: This is the simplest option, but it doesn't offer the same level of protection as a life insurance trust. If you die within three years of naming the trust as the beneficiary, the death benefit may be subject to estate taxes.
• Use a living trust: A living trust is a legal document that allows you to control your assets while you are alive and after you die. You can use a living trust to hold the life insurance policy and distribute the proceeds to your beneficiaries after you die. However, a living trust lacks the same level of protection from creditors as a life insurance trust.
• Purchase a second-to-die life insurance policy: A second-to-die life insurance policy pays out the death benefit when the second person dies. This type of policy can be used to provide for your spouse or other dependents after you die. However, it does not offer the same level of flexibility as a life insurance trust.
• Use a gifting strategy: You can use a gifting strategy to transfer assets to your beneficiaries while you are alive. This can help to reduce the size of your estate and avoid estate taxes. However, there are limits on how much you can give away each year without incurring gift taxes.

The Bottom Line

Placing a life insurance policy in a trust can help provide estate and tax benefits for you and your beneficiaries. However, before setting up a life insurance trust, keep in mind that there are many considerations to make, such as choosing the right type of trust, the financial needs of your beneficiaries and following proper estate planning laws and regulations.

Given the legal and financial complexities of setting up a life insurance trust and the long-term implications it can have for your estate and beneficiaries, seek professional guidance. Attorneys, accountants and financial professionals can provide a measure a confidence that your trust is established correctly, aligns with your objectives and adheres to legal and tax requirements.