Most people are familiar with how life insurance works: When you buy a life insurance policy on your life, you name one or more beneficiaries, who will receive the proceeds of the policy upon your death. Less familiar is a life insurance trust. When you set up a life insurance trust, the trust—rather than you—is the legal owner of the life insurance policy. Following your death, the person managing the trust (called a "trustee") distributes the proceeds of the policy to your beneficiaries in the manner you've specified in your trust document. Why this added complexity? In most cases, people turn to life insurance trusts in order to avoid or reduce estate taxes.
The Pros and Cons of Using an Irrevocable Life Insurance Trust (ILIT)
The type of life insurance trust that offers estate tax savings is called an irrevocable life insurance trust, or ILIT. The main draw of creating this type of trust is that the insurance proceeds—often a hefty sum—will not count as part of your estate for estate tax purposes (more on this below). In addition to estate tax avoidance, the ILIT offers a few other benefits:
Financial oversight. If your beneficiary is a minor or is not otherwise prepared to manage large sums of money, creating a life insurance trust can create a way for the beneficiary to receive payments from the insurance proceeds while the trustee handles the financial details.
Built-in flexibility. You can also leave many decisions about how and when to distribute the trust funds in the hands of the trustee. For example, you can give the trustee leeway to decide how to distribute the insurance proceeds to multiple beneficiaries (such as your children or grandchildren) over many years. The trustee might take into account factors such as the beneficiaries' changing educational or medical expenses, and the trustee could hold back on some portion in order to be prepared for unexpected emergencies. So instead of having a single lump sum go directly to your beneficiaries upon your death, relying on the trustee to hold and distribute the proceeds over time can be a more flexible, responsive alternative.
Protection from creditors. A properly drafted irrevocable life insurance trust can also protect the insurance proceeds from your creditors' claims. (Though some states do protect insurance proceeds from creditors even without an irrevocable trust, it's not always clear to what extent, so an ILIT can provide more security.) It's further possible to use an ILIT to protect the insurance proceeds from your beneficiaries' creditors, for example by having the ILIT pay the proceeds to yet another type of trust, called a "spendthrift trust." (If you're worried about creditors at all, it's best to speak to an attorney about your options; as you can see, estate planning can get quite complicated.)
On the other hand, there are drawbacks to the ILIT:
Irrevocability. In order to receive some of the benefits of an ILIT, such as estate tax savings and protection from creditors, you must set up the trust to be irrevocable, which means that once you create it, you cannot modify it. (By contrast, when you set up a "revocable living trust," you have the option to modify it or end it at any time.) The permanence and irreversibility of the trust understandably deters many people.
Less control. Not only is the trust permanent, but you must also turn over control of the trust to someone else—the trustee. So after it's created, the trust is essentially out of your hands.
Cost. You'll need a lawyer to draft the trust to suit your specific needs. This process is more time-consuming and costly than simply naming beneficiaries on your life insurance policy.
Should You Be Worried About Estate Tax?
Concern about estate tax is one of the primary reasons people create irrevocable life insurance trusts. The ILIT can be a powerful tool for avoiding or reducing your estate tax burden. But do you even need to worry about estate tax in the first place?
Currently, over 99% of estates will not owe federal estate tax. For deaths in 2023, your estate's total assets (meaning all of your property at the time of death) would have to total $12.92 million in order to trigger federal estate tax. In other words, federal estate tax isn't a concern for most Americans. That said, the threshold amount might not always be so high in the future; the federal estate tax exemption amount is subject to the political climate. Moreover, some states impose separate state estate taxes at much lower thresholds.
How an Irrevocable Life Insurance Trust Works
First, with the help of a lawyer, you will create a trust document that establishes the irrevocable life insurance trust and names the trustee and beneficiaries of the trust. You can also specify how payments will be made to your beneficiaries from the insurance proceeds following your death. After you've created the trust, you can either transfer an existing life insurance policy to the trust, or the trust can buy a new policy with funds you've placed in the trust. The latter option has advantages.
You will likely have a few options for paying the insurance premiums. Your options might include funding the trust upon creation, so that it can pay for future premiums; giving money to the trust each year to pay the annual premiums (but you might have to pay a gift tax on those sums); or purchasing a single-premium policy so that you face no future premiums. Be sure that the way you pay premiums doesn't accidentally give you an "incident of ownership" in the trust—to steer clear of this mistake, keep up to date on the latest tax court cases and IRS rulings (or rely on an experienced lawyer).
How to Create an Irrevocable Life Insurance Trust
To reap the benefits of an ILIT, the trust must be properly established and follow many administrative rules. Because irrevocable trusts can be very complicated and errors can have significant repercussions, it's vital to work with an experienced estate planning lawyer.