What Is a Life Insurance Trust?
A life insurance trust is a trust that is created to transfer ownership of a life insurance policy. If the insured owns the policy when he/she dies, then the death benefit of the policy is subject to estate taxes. With a life insurance trust, however, the insured can transfer ownership, making the proceeds exempt from estate taxes. The current maximum estate tax rate is 45%, which means the creation of a life insurance trust could save the beneficiaries hundreds of thousands of dollars. The proceeds of a life insurance policy are exempt from income tax regardless of whether a trust is created. In this post, we'll explain more about life insurance trusts and discuss some of the pros and cons.
Irrevocable Life Insurance Trusts
Life insurance trusts should be irrevocable, which is why they are often referred to as ILITs, or irrevocable life insurance trusts. An irrevocable trust is one that has no owner. The purpose of having an ownerless trust is to provide the opportunity to avoid taxes on multiple estates instead of just one. Usually, the ILIT is created for the benefit of the insured's children and/or spouse. The insured can transfer ownership of the life insurance policy to the trust by signing an irrevocable assignment form, which is available from the insurer or an insurance agent. Completion of the form indicates that the ILIT is the new beneficiary and owner of the policy.
The Tax Code & ILITs
An ILIT must be created at least three years in advance of the insured's death. The current tax code stipulates that the proceeds of the life insurance policy will be included in the estate for tax purposes if the insured dies within three years of when the policy was transferred. This does not mean that the proceeds will not be paid to the beneficiary. Rather, it means that the proceeds of the policy will be subject to estate taxes prior to being paid out. This clause of the tax code can be circumvented by having the trustee of the ILIT purchase the policy from the outset.
Drawbacks of a Life Insurance Trust
Though ILITs can save your beneficiaries a lot of money in estate taxes, they do have drawbacks. Consider the following disadvantages of an ILIT:
- The insured cannot change the beneficiaries of the policy. Once the policy is transferred, the trust becomes the beneficiary of the policy, and only the trustee has the right to change the beneficiaries.
- You forfeit the right to borrow from the policy. The insured cannot take out loans from the policy after it's transferred. If he/she does so, the insured will be named the owner of the policy for the purposes of estate taxes.
- You have to hire or find a trustee. The insured cannot serve as the trustee of his/her own ILIT. As such, the insured must find or hire a trustee. On the bright side, some trust companies and banks charge reduced fees for ILITs because they do not involve investment decisions.
