Insurance Trust

What Is an Insurance Trust?

An insurance trust is an irrevocable trust set up with a life insurance policy as the asset, allowing the grantor of the policy to exempt assets away from his or her taxable estate. 

Once the life insurance policy is placed in the trust, the insured person no longer owns the policy, which will be managed by the trustee on behalf of the policy beneficiaries when the insured person dies.

How an Insurance Trust Works

The life insurance trust, or irrevocable life insurance trust (ILIT), is often used to set aside cash proceeds that can be used to pay estate taxes, as the life insurance policy should be exempt from the taxable estate of the decedent. 

For the life insurance policy to not be included in the estate of the grantor, there would need to have been no incidence of ownership or have been transferred at least three years prior to death of the policyowner. This is assuming the policyowner is the same as the insured individual. To avoid incidence of ownership the trust grantor can have the trust apply for the insurance policy and be the owner from inception.

This eliminates the need to have the spouse acquire an insurance policy as an owner on a policy on the insured spouse, who would then subsequently transfer the life insurance policy into the irrevocable trust. There are issues with cross-ownership, such as, the unpredictability of the order of spouses' deaths and timing of death. In the event that the spouse other than the insured dies prior to the insured, the insurance will likely end up back in the insured's estate.

Steps that are ideal when establishing an ILIT:

1. ILIT is executed prior to policy application and any premium payment
2. Grantor transfer funds or gifts to ILIT for premium payments
3. ILIT trustee notify beneficiaries of Crummey withdrawal rights each time gifts are transferred to the ILIT.
4. ILIT trustee applies for policy on grantor's life as owner and beneficiary of the insurance policy.

In the U.S., proper ownership of life insurance is important if the insurance proceeds are to escape federal estate taxation. If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.) To avoid estate taxation, some insureds name a child, spouse or another beneficiary as the owner of the policy.

Beneficiaries do not have the power to make changes to an ILIT but they may have current withdrawal rights or powers under the Crummey powers.

Special Considerations

There are drawbacks to this sort of arrangement, as mentioned above. For instance, doing so may be inconsistent with the wishes of the insured or the best interests of the beneficiary, who might be a minor or lacking in financial sophistication and unable to invest the proceeds wisely. 

The insurance proceeds will be included in the beneficiary's taxable estate at his or her subsequent death. If the proceeds are used to pay the insured's estate taxes, it would at first appear that the proceeds could not be on hand to be taxed at the beneficiary's subsequent death. However, using insurance proceeds to pay the insured's estate taxes effectively increases the beneficiary's estate since the beneficiary will not have to sell inherited assets to pay such taxes. If the size of the taxable estate is below the maximum exclusion figure, it is generally not necessary to set up an insurance trust; in this case, the life insurance will be included in the decedent's taxable estate.