An individual with a life insurance policy on his or her own life who is concerned about taxes may be able to use a life insurance trust to reduce the size of the taxable estate. For individuals with taxable estates, estate taxes may consume up to 55 percent of their life insurance proceeds. The primary goal of a life insurance trust is to reduce or eliminate these taxes.
An irrevocable life insurance trust is specifically designed to hold and own life insurance policies. The settlor is the owner of the life insurance policy, which keeps the proceeds of the life insurance from the individual’s taxable estate. Once the trust has been established, the settlor transfers his or her life insurance policies to the trustee.
The settlor must be prepared to relinquish some degree of control. The settlor cannot be the trustee, or he or she would be deemed to have incidents of ownership in the life insurance, which lead to life insurance death proceeds. The settlor should choose a knowledgeable professional as the trustee. Likewise, the settlor cannot be a beneficiary, but his or her children can be beneficiaries. The settlor cannot change the beneficiaries or borrow from the policy or against it.
As the settlor makes gifts to fund the insurance premiums, he or she reduces the taxable estate. After the settlor’s death, the trust’s assets are available to the settlor’s beneficiaries free from income tax. Another benefit of an irrevocable life insurance trust is that, since insurance proceeds will be held in trust for the benefit of the settlor’s spouse, the proceeds cannot be taxed in the settlor’s spouse’s estate either.
When the trust receives death benefits from the life insurance policy at the settlor’s death, it can transfer the funds to the trust’s beneficiaries. Since the proceeds are outside the estate, the beneficiaries will not have to share any portion of the proceeds with the IRS.
Irrevocable life insurance trusts can also provide funds to pay estate taxes. The trust’s beneficiaries can use the proceeds from the life insurance policy to offset a portion of the taxes owed by the settlor’s estate. This allows the settlor to keep assets that are part of the taxable estate intact for his or her beneficiaries. This method is particularly useful if a large portion of the settlor’s estate consists of real estate, and he or she wants to ensure that his or her family will not be forced to sell the property to pay estate taxes.
If an individual already owns a life insurance policy and wants to take advantage of an irrevocable life insurance trust to shield the proceeds from estate taxes, he or she can transfer the policy to the trust. If the settlor dies within three years of the transfer, however, the IRS will pull the proceeds back into the settlor’s estate, and they will be subject to tax if the proceeds increase the value of the settlor’s estate by more than a certain amount.
The irrevocable life insurance trust is an effective way to avoid estate taxes without the problems associated with transferring ownership of the policy to the settlor’s children or their heirs. However, the law surrounding irrevocable life insurance trusts is complicated, and there is great variance among individual circumstances. An attorney or financial advisor is recommended to determine whether an irrevocable life insurance trust makes sense for an individual’s situation and can help manage the trust’s assets.