Tax Article - The Pros and Cons of Irrevocable Life Insurance Trusts

What is an Irrevocable Life Insurance Trust?

An irrevocable life insurance trust is a legal entity that owns the life insurance policies (and other assets) you move into it. Because the trust owns your life insurance benefits, the benefits aren’t included in your personal estate and are not used to calculate estate taxes.

A lawyer helps you set up the terms of your life insurance trust. Once you set it up, you cannot change the terms of an irrevocable trust. So it’s important to make sure that you contribute assets you won’t need later on. Also, be sure that the trust beneficiaries you choose aren’t people you might want to disinherit down the road.

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When you set up a trust, you will need to name a trustee to administer the trust. A trustee can be a bank, trust company, legal advisor, or any individual over the age of 18. But because trustees are responsible for paying life insurance premiums and managing the trust’s assets, you should pick a trustee with solid financial knowledge. Once you die, the trustee ensures that the proceeds of your insurance policies are paid to the trust’s beneficiaries or invests the proceeds and makes distributions to the beneficiaries over time.

Funding a Life Insurance Trust

The easiest way to fund a life insurance trust is by applying for a new life insurance policy when you set up the trust. You may also transfer existing life insurance policies into the trust. However, a transferred policy will still be included in your estate for estate tax purposes until three years have passed from the date of the transfer into the irrevocable life insurance trust.

You may also be able to make annual contributions into the irrevocable life insurance trust of up to $11,000 per beneficiary tax-free. These gifts can be used by the trustee to pay life insurance premiums. Your lawyer will have to draw up special paperwork to take advantage of the annual gift-tax exclusions.

The Pros and Cons of Irrevocable Life Insurance Trusts

You may find that setting up an irrevocable life insurance trust is the answer to your estate tax concerns. There are many good reasons to consider a trust:

• The proceeds of your life insurance policy are removed from your estate and become free of estate taxes.
• The trust does not pass through the public probate process.
  
• Beneficiaries can use trust proceeds to pay estate taxes.
  
• Proceeds held in the trust may be protected from the creditors of the trust beneficiaries.
  
• If you are married, you can arrange for your spouse to receive income from the trust during his or her lifetime.

But before you set up a trust, consider these potential drawbacks...

• Once the trust is set up, you can’t change its terms.
  
• Once you transfer a life insurance policy to the trust, you 1) give up control over that policy, 2) can’t make loans or withdrawals of the cash value of that policy, and 3) can’t change its beneficiaries.
  
• Trustees and legal advisors must carefully handle gifts made to the trust to prevent triggering gift taxes.
  
• Professional trustees usually charge annual administration fees and may not agree to manage smaller trusts.

Setting Up a Trust

To set up a trust you should talk to a lawyer who specializes in trusts or estate planning. Because you cannot change an irrevocable trust later, it’s crucial your legal advisor is knowledgeable about the tax laws and able to get the terms of the trust straight now. You may also need to consult an insurance agent or other financial professional about purchasing a life insurance policy that is appropriate for an irrevocable trust.

In addition to legal fees, you may need to pay trustees annual maintenance and other administrative fees.

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