Q

What is a life insurance trust?

A

An irrevocable life insurance trust decreases your taxable estate. It is used so that the life insurance death benefit doesn’t impact how much your heirs will need to pay in estate taxes.

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By 

Nupur Gambhir

Nupur Gambhir

Senior Editor & Licensed Life Insurance Expert

Nupur Gambhir is a licensed life, health, and disability insurance expert and a former senior editor at Policygenius. Her insurance expertise has been featured in Bloomberg News, Forbes Advisor, CNET, Fortune, Slate, Real Simple, Lifehacker, The Financial Gym, and the end-of-life planning service Cake.

Updated  | 4 min read

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If you’re buying life insurance as a part of your estate plan, you may want to consider a life insurance trust. For individuals with a high net worth, life insurance trusts shield the death benefit from estate taxes and probate. A life insurance trust can also be used to ensure the proceeds are spent according to your wishes. 

Trusts designed specifically for this purpose are called irrevocable life insurance trusts (ILIT). Because they are irrevocable, they cannot be modified or dissolved after they are put in place. Irrevocable life insurance trusts are very complex and should not be formed without consulting an estate attorney or certified public accountant (CPA). 

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Life insurance and estate taxes

The life insurance death benefit is generally paid out to your beneficiaries untaxed. But, it can still be counted toward the value of your estate when it is paid directly to your estate or in incidents of ownership, which is when the insured individual is also the policyholder. More often than not, the insured and policyholder must be the same person.

Because life insurance payouts can be a lot of money, when they are added to the valuation of an already sizable estate, they can either:

  1. Increase your taxable estate

  2. Push your estate’s worth over the limit where it is no longer exempt from the estate tax

In 2022, the value needs to exceed $12.06 million for it to be subject to federal estate taxes. [1] Married couples are able to double this number. Some states and Washington, D.C., have lower exemptions.

If your estate is large enough, then a life insurance trust allows you to legally shelter some of this money so it is not subject to the estate tax.

What is an irrevocable life insurance trust (ILIT)? 

Trusts are often used in estate planning to protect assets from taxes and transfer wealth to your heirs. Irrevocable life insurance trusts are sometimes incorporated into an estate plan so that a life insurance policy doesn’t increase a taxable estate.

With an irrevocable life insurance trust, the trust owns the policy, removing any incidents of ownership. Only the policyholder can pay life insurance premiums. So you fund the trust, and the funded trust then pays the life insurance premiums. 

With the trust as the policyholder, the money is no longer considered a part of your estate and therefore does not increase the value of your estate for tax purposes. It also won’t be subject to probate and your heirs can receive the life insurance death benefit in its entirety. 

The trust is also the beneficiary of the life insurance policy. When you die, the death benefit will pay into the trust, which will then distribute it according to your wishes.

How does a life insurance trust work?

Once you establish a trust, you can either transfer an existing life insurance policy into the trust or purchase a new policy entirely. The one stipulation to keep in mind is that there is a three-year look-back period imposed by the IRS. If you die within three years of transferring the policy into the trust, the benefit still counts as part of your estate. 

Crummey powers

Because the federal government taxes gifts with a future interest, the money used to fund an irrevocable life insurance trust is subject to a gift tax by the IRS. But using something called Crummey powers, up to $15,000 can qualify for the federal gift tax exclusion annually. To do so, you will need to give the trust beneficiaries the ability to withdraw a limited amount of contributions within a certain period of time. If they miss the deadline given to them, their rights to withdraw the money expire. 

Crummey powers are often used when creating life insurance trusts and transferring wealth. 

How to set up a life insurance trust  

You’ll need to make a few key designations when setting up your trust:

  • The grantor: The insured individual whose death prompts the death benefit payout.

  • The trustee: The administrator of the trust.

  • The trust beneficiaries: The recipients of the funds from the trust.

Once you decide who will be listed in your trust, work with an attorney to set up the life insurance trust. There are four steps you’ll need to take:

  1. Open and finance the trust. You’ll need to fund the trust to maintain the life insurance policy’s premium payments.

  2. Select a trustee. The trustee is the administrator of the trust and must be a different person than the grantor. 

  3. Purchase or transfer a life insurance policy. An existing or new policy can be put into a life insurance trust. 

  4. Choose how the trust will make distributions to your heirs. You need to designate your distributions in the trust document, which cannot be changed at a later date.

When you, the grantor, dies, the life insurance policy will then pay into the trust. The funds are then used according to the designations you spelled out in the trust document. 

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Who should have a life insurance trust?

Most people don’t need to incorporate the complexity of a life insurance trust into their end-of-life planning. Because the trust cannot be changed after it’s established, it’s best for people with specialized estate planning needs.

Individuals with a high net worth may find an irrevocable life insurance trust to safeguard their heirs against higher estate taxes. Parents who want their policy proceeds to be used to benefit their minor children can use a life insurance trust to guarantee the benefit is spent on their child's care and doesn't get tied up in court.

Irrevocable life insurance trusts are complex and come with a lot of tax implications. It’s vital to consult with an attorney when you’re creating a life insurance trust to ensure it is properly implemented and works to your benefit. 

Frequently asked questions

How does a life insurance trust work?

A life insurance trust is the policyholder and the beneficiary of a life insurance policy. The trust funds the policy premiums, which are funded by the insured. Life insurance trusts are irrevocable and cannot be changed or modified after the initial trust document is drawn up.

Should I put my life insurance in a trust?

If a life insurance policy will increase your taxable estate or if you want your minor children to benefit from your policy, a life insurance trust may be worthwhile.

What is the purpose of an insurance trust?

A life insurance trust is a legal shelter for money that would otherwise be subject to taxes and a way to control how the death benefit is spent.