What Is a Life Insurance Trust?
Life insurance is an excellent way to plan on providing for your family after your death. Taking that plan to the next level with a life insurance trust is a good way to protect those assets, help your beneficiaries avoid taxes and provide faster access to the funds. However, establishing a trust can be a rather complicated process.
Read our following guide to life insurance trusts to learn more about how they work, their pros and cons and how to set one up to benefit your heirs after your passing.
What is a life insurance trust?
A life insurance trust is a legal entity you set up that takes ownership of your life insurance policy. Since the trust owns your life insurance policy, your estate doesn’t include the death benefit when you pass away, which helps your heirs avoid estate taxes. There are pros and cons to using this method to protect your life insurance proceeds, and you must meet certain legal requirements in order to maintain the trust.
How life insurance trusts work
Life insurance trusts are set up in a way that the insured has no control over the policy or its proceeds. Instead, the insured sets up the trust to take ownership of the policy and names someone else as the independent trustee.
Even though life insurance trusts limit your long-term control, you are responsible for dictating:
- Who's in control of the trust
- How the trust pays the life insurance premiums
- Who receives the life insurance death benefit
- How the trust makes payments to the beneficiary upon your death
Life insurance premium payments are made by the trust through your funding "gifts." You pay the trustee, who should then deposit those payments into the trust’s checking account, which can then be used to pay for the policy’s premiums.
Types of life insurance trusts
There are two types of life insurance trusts: revocable and irrevocable.
1. A revocable life insurance trust leaves the insured in control of the trust during their lifetime, meaning they can make changes if desired or end the trust entirely if done so before the time of their death.
2. An irrevocable life insurance trust (ILIT) is permanent and thereby limits control. The insured must designate a trustee to take control of the trust and its proceeds, which cannot be changed once established.
Why put life insurance in a trust?
In the following section, we discuss some of the advantages insurance policyholders can expect from establishing a life insurance trust.
Estate tax planning
Whether with a revocable trust or ILIT, since the trust takes ownership of the policy, the death benefit goes to the trust before being paid to the life insurance policy’s beneficiary. In this regard, it's a good tool for estate tax purposes because it reduces the taxable estate.
While assets left out of the trust could be subject to state and federal estate taxes, the death benefit and other proceeds in an ILIT wouldn't be. Additionally, using a life insurance trust will help lower your taxable estate if it exceeds state or federal thresholds. In 2023, the federal estate tax threshold is $12.92 million. State thresholds vary, but 33 states don’t have estate taxes at all.
Asset protection
Life insurance trusts are not subject to claims by the insured’s creditors. Therefore, if you die and still owe money for a mortgage or other loan, your creditors can’t take proceeds or demand payouts from the trust or its beneficiaries. Additionally, the beneficiary could use the trust to directly pay bills or make purchases rather than taking cash payouts that could then be subject to claims by the beneficiaries’ creditors.
Avoiding probate
Probate is the legal process that requires an executor to distribute assets according to a will. Probate can take anywhere from a couple of months to a couple of years depending on the particular state’s procedures and the estate planning done by the deceased before passing away. By using a life insurance trust, you can bypass the entire probate process and give almost immediate funding to the life insurance trust’s beneficiary.
The disadvantages of a life insurance trust
Even with proper planning, setting up a life insurance trust for a beneficiary has its drawbacks. The following section explains some of those disadvantages.
Loss of control
To take full advantage of a life insurance trust and entirely avoid estate taxes, you’re required to have an ILIT. However, the whole point of an irrevocable trust is to take control away from the insured. While the insured can make decisions about how the trust is initially set up, they will not have the right to make changes to the trust to reclaim ownership of the life insurance policy at a later date.
Funding and maintenance costs
In addition to making premium payments to your life insurance company, you will also need to pay fees to get your trust set up. Those expenses can vary considerably depending on who you work with and how many life insurance policies you include in the trust. Many trust companies will charge a one-time setup fee plus ongoing maintenance fees based on how many policies are in the trust. Additionally, you may need to pay service fees for financial advisors or lawyers.
Gift tax implications
Gift tax exemptions are available for revocable life insurance trusts to avoid gift taxes both before and after the insured’s death, but these taxes can be confusing. Working with a financial advisor is the easiest way to keep track of potential gift tax implications. If you exceed the annual gift tax exclusion by funding over the limit in a tax year, you may need to file a gift tax return. In 2023, the IRS has set that limit at $17,000.
Deposits into ILITs generally do not qualify for gift tax exemptions unless beneficiaries are given the right to withdraw the funds. The trustee should notify beneficiaries of these “Crummey” powers, which allow them to make withdrawals for a specified period after the gift has been deposited. While the beneficiaries should leave the deposit in the trust to pay the insurance premiums, the notification of their rights is enough to help reduce gift taxes.
What is an irrevocable life insurance trust?
An ILIT simply refers to a life insurance trust used to limit the insured’s control over the policy and avoid taxes that could potentially stem from the death benefit. The term “irrevocable” means that the insured cannot make changes after creating and funding it. An ILIT is required to be irrevocable and must include at least one permanent life insurance policy. Because ILITs are irrevocable, make sure you work with experienced lawyers, financial advisors and the best life insurance companies so that the trust is set up exactly how you want it to be.
How to set up a trust for life insurance
1. Determine the purpose and type of trust
Before setting up your trust, you must consider the types of trusts available to you. As previously mentioned, life insurance trusts can either be revocable or irrevocable. While revocable trusts don’t have as many tax benefits, they leave you in control in case you want to make changes in the future before you pass away. Irrevocable trusts require you to relinquish control to a trustee, but they help your beneficiaries avoid estate taxes and protect your assets from creditors. Both types of trusts avoid probate and provide the fastest access to funds for your heirs upon your death.
2. Choose trustees and beneficiaries
You'll also need to decide who is going to benefit from the trust. If you choose to set up an irrevocable trust, you will appoint a trustee. The trustee should be unrelated to the insured or beneficiaries and have an impartial role in ensuring that the trust is administered in accordance with its instructions and how it was set up.
Beneficiaries are the ones who will receive proceeds from the trust after your death. You can specify who or what (e.g., a trust, foundation or business) gets how much and how the money can be used. For example, you might specify that your children need to use the money for educational or housing expenses, or a business partner must use funds for operating costs and payroll.
3. Draft the trust document
Work with an experienced estate attorney to set up your trust documents. They can help you ensure your trust meets all legal requirements and that you’re properly allocating your life insurance proceeds the way you intend to. Working with a professional is especially important when setting up an ILIT since you won’t be able to make changes in the future.
4. Fund the trust
Before funding a life insurance trust, research how much life insurance you need and the type of policy you want to purchase, whether whole, term, survivorship, no-exam, high-risk or another. Your family’s current and expected financial situation is a significant factor that can help you determine how much life insurance to buy.
Also consider your debts, income that will need to be replaced, educational costs or end-of-life expenses, which things like burial insurance can help mitigate. A financial advisor can also help you determine how much life insurance is appropriate for your situation.
Most people who set up a life insurance trust opt for permanent life insurance since it lasts for your entire life and you don’t need to worry about having the trust purchase a new policy. While term life insurance is more affordable, your rates may increase significantly at the end of the term. Take some time to compare term versus whole life insurance and other types of coverage to make sure you’re picking a policy with all of the features you need.
You will need to sign paperwork that lists the trust as the owner and beneficiary of the policy and continuously fund the trust so it can continue making insurance premium payments.
5. Comply with legal requirements
Revocable trusts are generally easy to set up and are subject to few legal requirements since they aren’t generally used to avoid taxes. On the other hand, irrevocable trusts are subject to some legal requirements and must be set up properly to qualify for tax exemptions. The insured must give up control to a designated trustee and waive their rights to make changes to the trust in the future. Additionally, the insured must transfer existing assets to the trust at least three years before their death to qualify for tax exemptions and avoid probate.
6. Review and update the trust document as needed
As previously mentioned, irrevocable life insurance trusts cannot be changed after they are established. Therefore, you'll only need to review documents to ensure that premiums get paid and the trustee and beneficiaries are following any instructions you give them.
You should review revocable trusts regularly since you can continue making changes to them before your death. For instance, revocable trusts might be a good option for growing families that expect to add more children or other family members as beneficiaries, which would require you to make adjustments to existing terms.
Are life insurance proceeds from a trust taxable?
Your tax burden will depend on how you establish your trust. A revocable trust that allows the insured to maintain control and make changes can be subject to taxes, especially if the trust is used to provide income to beneficiaries.
Regarding life insurance death benefit proceeds, at the federal level, estate taxes can generally be avoided so long as the federal threshold of $12.92 million is not exceeded. At the state level, it depends on where you live. Currently, 33 states do not have estate taxes, and in states that do have them, thresholds vary but are generally lower than the federal threshold.
Gifts made to a revocable trust for the purpose of paying insurance premiums are not subject to gift tax as long as they are under the annual gift tax exclusion. However, gifts of any amount made to irrevocable trusts are generally still subject to gift tax unless the trustee notifies beneficiaries of their Crummey powers to withdraw.
Should a life insurance policy be in a trust?
Placing a life insurance policy in a trust has several benefits. It can help the recipient(s) of the death benefit not have to endure the probate process and, in turn, can provide beneficiaries with access to the funds sooner in order to cover end-of-life expenses or their own living costs. Additionally, it can minimize estate taxes, which is helpful if your estate exceeds the federal or state estate tax thresholds.
It’s recommended that you work with a professional so your trust is set up exactly the way you intend it to be. Giving up control of your life insurance policy is a big decision, so make sure you take plenty of time to conduct your research and put careful thought into how you establish your trust.
Summary of Money’s definition of a life insurance trust
A life insurance trust is a legal entity that takes ownership of your life insurance policy. It has numerous benefits, such as reducing estate taxes, allowing heirs to bypass the probate process and protecting the policy’s death benefit from estate taxes. However, the insured may still be subject to gift taxes. Additionally, the insured must surrender control to a trustee, and in the case of an irrevocable trust, cannot make changes to the trust.
The best life insurance for a trust is generally a permanent policy that's easy to manage. Before gifting the policy to a trust, make sure you work with professionals, including lawyers and financial advisors, to establish your trust the best way possible for you and your beneficiaries.