Life insurance trust

A life insurance trust is a trust that is set up for the purpose of owning a life insurance policy. The idea is that if it is an ILIT, an irrevocable life insurance trust, that the trust itself is the policy holder and owner, the payer is the trustee (given money from the settlor aka the settler) and the beneficiary and/or benefiriaries get the entire death benefit free of taxes (estate taxes, inheritance taxes, and the death tax) even if this figure is well over the current exemption limit! If the insured is the owner of the policy, the proceeds of the policy will be subject to estate tax when he dies. But if he transfers ownership to a life insurance trust, the proceeds will be completely free of estate tax. (The proceeds will be exempt from income tax either way.)

Given the current estate tax rate of 46% (in the USA), a life insurance trust can save hundreds of thousands of dollars in estate taxes. However, there are several drawbacks to such an arrangement:

1. You can't change the beneficiary of the policy.

The insured must give up the right to change the beneficiary of the policy (the trust itself will be the beneficiary). The trustee alone has that right, and the insured cannot serve as trustee of his own life insurance trust. Of course, the insured will designate the beneficiaries of the trust (for example, his children). But because this designation cannot be changed after the life insurance trust has been set up, the insured will lack the flexibility to deal with changed family circumstances with this particular policy.

2. You can't borrow from the policy.

The insured can no longer borrow against the policy. If the trust allows him to borrow against the policy, he will be deemed to be an owner of the policy for estate tax purposes.

3. You can't transfer an existing policy to the trust -- unless you live for at least 3 more years.

If the insured transfers an existing policy to a life insurance trust and dies within the next three years, he will be treated as the owner of the policy and it will be taxed in his estate. Even if he survives another three years, he will have made a taxable gift in the amount of the cash value of the policy (of course, this is usually preferable to having the entire face value subjected to estate taxes). If the life insurance trust takes out a new policy on the insured's life, however, the insured will never be deemed to own the policy. Furthermore, no cash value will have built up yet, so no taxable gift will be made.

4. The life insurance trust must be irrevocable.

Once you set up and fund the trust, you cannot get the policy back. If you become uninsurable, you will be committed to this trust as your only life insurance.

5. Premium payments may use up your estate tax exemption.

If the policy has not yet endowed, you must find a way to pay the premiums without using up your estate and gift tax exemption. If you transfer securities to the trust so that the trustee will have income with which to pay the premiums, the full value of the securities will be a taxable gift. If you transfer cash to the trust each year to pay the premiums, each transfer will be a taxable gift. However, you may be able to exempt these premium payments from gift or estate taxes by setting the life insurance trust up as a Crummey Trust. Then each premium payment can be sheltered by your annual gift tax exclusion, which is $12,000 (indexed for inflation) per trust beneficiary.

6. You must find and/or hire a trustee.

The insured cannot serve as trustee of the life insurance trust. That means that he will have to find or hire a third party trustee. However, many banks and trust companies offer reduced fees for life insurance trusts because they involve essentially no investing decisions. The best thing to do is to hire a well qualified J.D. Lawyer (not a paralegal, bank, brokerage, or insurance house) that specializes in Estate Planning Law to handle the drafting and design of the trust as well as the trustee tasks. Getting a well qualified lawyer to handle the drafting and design of the trust can potentially save many tens of thousands of dollars versus prices and costs from other entities (including banks & brokerages & insurance houses). Additionally, only lawyers/attorneys that ordinarily specialize in this area are qualified to get the trusts validated, endorsed, and executed shortly after materialization of the death certificate (banks, brokerages, insurance houses may have to charter off a lawyer/attorney to do this for an additional fee) so it is best to find a J.D. lawyer initially that will handle and validate, get endorsed, and execute the trust [from start to finish so to speak] for those interested in ILITs.

Despite these drawbacks, many people find that the tax saving potential of a life insurance trust is worth the cost and hassle. It allows you to remove from your estate a significant asset that you are unlikely to want access to during your life. And it ensures that the life insurance proceeds go 100% to the beneficiaries, not the federal government.

Irrevocable Life Insurace Trusts (ILITs) are primarily used as an advanced estate planning procedure/technique/tactic/strategy, in that the proceeds (or some of them) may be used to pay for the estate tax--- while the rest of the insurance proceeds may be used for estate preservation, estate conservation, and estate creation. The ILIT allows the death benefit to not be included in the gross estate, and also since the insurance policy is in the ILIT the proceeds pass tax free to the beneficiary and/or beneficiaries--- even if well over the current exemption limit. Many are finding that life insurance policies are a great way to finance estate creation (or conservation or preservation), and also to finance great gifting to 501(c)-3 corporations upon materialization of the death certificate. ILITs can definitely help to pass more money to any heirs or beneficiaries, to donate large quantities of money to charities such as orchestras, parks, churches, hospitals, universities and/or colleges upon materialization of the death certificate.

Wikimedia Foundation. 2010.

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