Creating a life insurance trust provides a planning opportunity to help your loved ones enjoy a lifetime of financial security and inherit more of your wealth. At the same time, it allows you to control how and when they receive that wealth, which can protect it from creditors and unwise decisions.
Further, a trust keeps those distributions out of the public record, unlike the asset transfers handled after death by probate courts. Here are some key details to know.
What is a life insurance trust?
A life insurance trust is a fiduciary arrangement whose main purpose is to own a contract that matures when the insured passes away. The trust can be revocable (changeable) or irrevocable (mostly unchangeable) and is usually the named beneficiary of the insurance contract. You can use life insurance trusts to support your loved ones financially as a thoughtfully structured part of your
ILITs can help heirs reduce their tax burden
If your net worth is high enough that it may be subject to
When the insured transfers ownership of an existing life insurance contract to an ILIT, the proceeds will typically not be subject to federal estate tax if the contract was transferred more than three years before the insured's death.
Under federal law, the portion of the taxable estate value that exceeds the estate tax exemption plus $1 million is taxed at 40%. The first $1 million is taxed progressively at rates ranging from 18% to 39%. Using a trust is a legal way to avoid these taxes and can safeguard substantial sums for families and charitable beneficiaries.
Life insurance trust benefits
The main reasons you might choose to set up an ILIT are for these advantages:
Avoid federal and state wealth transfer taxes
When an insured dies, the life insurance contract's beneficiaries do not owe tax on the death benefit they receive. However, the death benefit may be considered part of the deceased's estate if the insured owns the contract. When an
Leave a structured inheritance
Instead of your heirs receiving death benefits directly when your contract matures, the trust is made the owner of the contract and then the trust can be changed to be the beneficiary. The trustees must then follow the rules you've established in your trust documents. For example, the trust might only make discretionary distributions for specific purposes until the beneficiary has reached a certain age.
This advantage can be especially meaningful when you want to provide for minor children or family members with special needs.
Provide cash for estate taxes
If your estate may be subject to federal or state
Reduce life insurance premiums
Holding life insurance in an ILIT may mean that you need a smaller death benefit with correspondingly lower premiums if you anticipate that the benefit will be protected from estate and inheritance taxes.
Life insurance trust drawbacks
People who establish trusts accept the following drawbacks when they expect the trust to generate benefits—such as tax savings—that exceed the costs.
- Complexity. Trusts must follow many rules to hold up to IRS challenges. For example, instead of paying your life insurance premiums directly, you may need to pay them indirectly. You might use your annual
gift taxexclusion amount ($17,000 in 2023) or a portion of your lifetime gift exclusion ($12.92 million in 2023) to make a gift to the trust. Then, the trust will pay the contract's premiums. You may need to file gift tax returns as a result.
- Cost. Creating any trust has costs. You'll pay for the legal documents that establish and govern the trust, and you'll pay for someone to manage the trust. With a Thrivent ILIT, you'll pay a one-time setup fee, an annual fee based on the number of contracts held by the trust and a distribution fee.
- Loss of control. With an irrevocable life insurance trust, you will not own the life insurance contract. You won't have access to its cash value nor will you be able to cancel it or change its beneficiaries. This may not feel like a big deal if the trust is purchasing a new contract. The implications may be more substantial when transferring an existing contract to the trust.
- Timing. If the insured is terminally ill, it may be too late to create a life insurance trust. The insured may not qualify for a new contract that is cost-effective. And the three-year waiting period to qualify for estate tax exclusion with an ILIT may preclude the strategy of transferring an existing contract to the trust.
Funding your life insurance trust
After creating your life insurance trust by drawing up and signing the trust documents, you must fund your trust to make it effective. Whether your trust is revocable or irrevocable, you can fund it with an existing life insurance contract or a new one.
- Existing contract. To fund your trust with an existing life insurance contract, you'll need to change the contract's owner. Typically, the insured is the owner. The trust will need to be the owner instead. You may also need to change the contract's beneficiary to the trust depending on how you want the death benefit to be distributed.
- New contract. Funding your trust with a new contract avoids the three-year waiting period problem and may be an option if your health qualifies you for a contract that meets your needs. Unlike an existing contract, a new contract can be tailored for the specific purpose you're currently trying to meet.
While you can fund the trust with any type of life insurance, the gold standard is to fund it with a permanent
Help with setting up a life insurance trust
If you've never created a trust before, it can feel daunting to do it for the first time. But establishing a trust is not a task that's meant to be done alone. It's a sophisticated wealth planning strategy that should only be undertaken with the guidance of an experienced estate planning attorney and financial advisor.