Using Life Insurance to Fund a Trust
Using life insurance to fund a trust is a strategy that combines estate planning with asset protection. It can provide liquidity for estate taxes, offer support to beneficiaries and provide control over how and when assets are distributed. When structured properly, this approach helps preserve wealth, while minimizing tax exposure and family conflict.
Why Use a Trust to Hold a Life Insurance Policy?
When a person owns a life insurance policy in their name, the death benefit becomes part of their estate. This can increase the taxable estate and delay access to funds during the probate process. By contrast, placing the policy in an irrevocable life insurance trust (ILIT) removes it from the taxable estate.
In this arrangement, the trust serves as both the policy owner and beneficiary. When the insured dies, the death benefit goes directly into the trust. The trustee can then distribute funds according to instructions in the trust document, whether for paying estate taxes, supporting minor children, or funding a business transition.
Advantages of Using an Irrevocable Life Insurance Trust (ILIT)
An ILIT offers greater control over how the life insurance proceeds are used. The trustee can manage the funds over time, rather than issuing a lump sum payment to the beneficiaries. This is especially useful when the beneficiaries are minors, have disabilities, or are at risk of financial mismanagement.
The proceeds also avoid probate and are generally protected from creditors, depending on the jurisdiction in which they are held. The trust can also contain rules for triggering distributions – for example, funding education, medical expenses, or home purchases – without handing over complete control.
Points to Consider Before Creating a Trust
An ILIT must be irrevocable, meaning you cannot make changes once the trust is funded. It must also be created before applying for the life insurance policy, or the IRS may still consider the policy part of your estate.
Annual premiums paid into the trust may be considered gifts to the trust’s beneficiaries. To avoid gift tax, these payments should be structured carefully, often using what’s known as “Crummey notices” to qualify for the annual gift tax exclusion.
Because of these technical requirements, an experienced estate planning attorney should be involved from the start. Using life insurance to fund a trust can be a wise choice. Life insurance trusts can be powerful tools, but only if set up and managed correctly.
Key Takeaways
- Life insurance trusts protect estate value: Placing a policy in a trust keeps the death benefit out of the taxable estate and out of probate.
- ILITs offer control and protection: Trustees can distribute proceeds according to long-term goals rather than in a lump sum.
- Setup must follow IRS guidelines: To avoid tax consequences, the trust must be properly structured from the beginning.
- Gifting rules apply to premium payments: Careful planning ensures that premium payments qualify under gift tax exclusions.
- Legal advice is essential: Trust and tax laws are complex, and mistakes can undermine the benefits of the trust.
If you would like to learn more about the role of life insurance in estate planning, please visit our previous posts.
Reference: J.P. Morgan (Nov 27, 2024) “When Does It Make Sense for a Trust to Own Your Life Insurance Policy?”
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