An Irrevocable Life Insurance Trust is designed to hold life insurance for the beneficiaries. Many people create these trusts so that the IRS will not include the proceeds from the life insurance in their estate when they pass away. When a person owns a life insurance policy they retain the rights to change the policy, take withdraws from the policy, assign the policy, and change the beneficiaries. Because of these rights, the person has “incident of ownership” and the IRS will include the life insurance policy as part of their estate asset when the owner passes away. With the inclusion of the life insurance proceeds in the estate, the estate may need to pay federal estate taxes if their net estate amount is over $5.6 million in 2018.
The net estate, for estate tax purposes, is found by adding up all of assets then subtracting all the debts at the time a person passes away. If this amount is over the federal exemption ($5.6 million) then their estate will need to pay estate taxes. For these individuals, it is beneficial to create an irrevocable life insurance trust for their life insurance policy ,so that the proceeds from the policies are not included in the net estate.
A life insurance policy may be bought by the trust after the trust is created or the life insurance policy may already exist and transferred to the trust. The trust is irrevocable which means the terms of the trust can’t be changed or dissolved. In order to change the trust or dissolve the trust, the person who created the trust would need court approval.
The person whose life is insured may not be the trustee of the trust. If they were the trustee then “incident of ownership” would occur because that person would retain control over the policy. Sometimes, the trustee of the trust will be their spouse, children, their attorney, or financial advisor.
The trust may be the beneficiary of the life insurance or the proceeds may be given directly to the beneficiaries. The beneficiaries will most likely be that person’s spouse and/or their children.
There are plenty of benefits from having a life insurance trust. First, it will provide for a spouse, children, and continue to provide if they are incapacitated. Second, the proceeds will not go through probate but be available to the beneficiaries. Thirds, the proceeds will avoid estate taxes and income taxes. Fourth, the funds may be used to pay for estate taxes and other expenses after death. Fifth, there is some control over the insurance policy.
However, like everything else, there are some pitfalls when creating a life insurance trust. First, if the policy is transferred to the trust within three years of the owner passing away, the IRS will include the proceeds in their net estate. Second, if the policy is transferred within five years of apply for and being approved for Medicaid, then a divestment has occurred. That person or their spouse might not be able to receive Medicaid for a period of time. Third, the same is true if the person pays any premiums for the policy within five years of apply for Medicaid, a divestment has occurred. That person or their spouse might not qualify for Medicaid assistance. Fourth, if you transfer money directly to the trust, there could be a gift tax. The annual gift tax for 2018 is $14,000 any amount over $14,000 can result in a gift tax. The amount would need to be claimed off their lifetime exemption/estate tax. Fifth, the trustee, must notify each beneficiary of the “gift” each year that money is given to the trust. If the beneficiary decides to take the gift rather than have the “gift” pay the premiums the insurance policy could lapse.
Always talked to a qualified financial advisor, accountant, and attorney before creating the life insurance trust. Remember the trust is irrevocable, so once the terms of the trust are set, you may not be able to change the trust after you created the it.