What is a Life Insurance Trust?

A life insurance trust is an irrevocable trust which holds a life insurance policy on the grantor. A life insurance trust is a good option for anyone who would be in danger of exceeding the estate tax exemption when their life insurance policy pays out. This type of trust reduces your taxable estate as well as allows you to designate how and when your policy is paid out.

How does a life insurance trust work?

By creating an irrevocable trust, the grantor effectively relinquishes possession of the policy on his life. This then removes the policy from his taxable estate, reducing the estate tax burden on his heirs. Upon the grantor’s death, the policy pays the trust which can then invest the proceeds or pay them to the beneficiaries as the trust dictates.

Who pays the premiums on the policy?

There are two common ways that the premiums are paid on a life insurance trust:

1. Income generating assets are placed in the trust to pay the premiums
2. The grantor makes a gift to the trust on behalf of the beneficiaries

The first option often has gift taxes associated with it, and as such is not as favorable as the second option. If set up properly, the second option can utilize the yearly gift tax exemption to allow the premiums to be paid without paying additional taxes. The second option is what is known as a “Crummey Trust” and should be set up with the advice of an attorney to ensure that the subtleties will provide the most tax advantages.

Requirements of a life insurance trust

There are a few requirements of a life insurance trust in order to ensure that it provides all the tax advantages to the grantor and the beneficiaries. First, as mentioned above, it must be irrevocable. A revocable trust provides the grantor with legal rights over the property, and therefore is still seen as the grantor’s property. In order to be completely removed from the grantor’s estate, the grantor must surrender legal possession to an irrevocable trust. Second, the grantor cannot be the trustee, for the same reasons that the trust must be irrevocable. Third, the trust must exist for at least three years prior to the death of the grantor. This rule was created to avoid last minute transfers of property to the trust. If the grantor dies within three years of the trust being created, then the trust does not provide any estate tax savings.

Altering a life insurance trust

There are times when the provisions of the trust may need to be altered: divorce, new children, or other unforeseen circumstances. In these cases, there are many legal intricacies that must be navigated by a trained estate planning professional, and it is best to seek the advice of an attorney familiar with these matters.

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