At its most basic level, life insurance + trust = life insurance trust. On its face, this seems pretty self-explanatory, but it probably still leaves you with a lot of questions. Is a life insurance trust right for me? What questions should I ask as I’m setting one up? Can I do that myself, or should I get a lawyer, or another kind of estate planner?
Why should I consider a life insurance trust?
You may not realize this, but the IRS can consider the proceeds from your life insurance policy as part of the estate for tax purposes. However, this isn’t a hard-and-fast rule. The best way around it is to form an Irrevocable Life Insurance Trust. This trust will then both own and be the beneficiary of a life insurance policy.
The trust is irrevocable, because in order for it to not be part of your estate, you must completely step aside as owner. You can have a trusted family member or financial or legal professional administer the trust for you.
If you have a preexisting policy, you can form a trust and transfer your policy to it. You can also have the trust itself purchase the policy.
Since you are not listed as the owner of the life insurance policy, the proceeds from it cannot be considered part of your estate. This means it can’t be taxed under the steep estate tax rate.
While estates are not taxed until after they exceed $5 million, you might be closer to that number than you think. Not only that, but many states impose lower thresholds. Doing a little research on your state’s estate tax policies can prove to save you a lot of money!
What are the drawbacks to a trust?
Since the trust is irrevocable, this means you must completely step aside as owner, and cannot make any changes. This includes changing the trust beneficiaries, dissolving the trust, or in some other way altering the trust. We would normally recommend looking over your estate plans every few years to ensure they are still aligned with your wishes. Having an unchangeable life insurance policy with your now-ex-spouse as a beneficiary is an expensive error. In order to dissolve the trust, you generally must allow the policy to lapse. This means you lose all the premiums you’ve paid in.
Another drawback is that if you pass away within 3 years of transferring your policy to the trust, the policy will still be counted among your assets.
What do I need to do to form a life insurance trust?
Life insurance trusts are extremely dependent on individual circumstances. Because of this, it is a good idea to consult with a lawyer as you establish the trust. They can advise you on how to best fund your trust and pay for your policy. They can also help with figuring out how to designate a good beneficiary, and even serve as trustee.