Understanding life insurance trusts

A life insurance trust is a type of living trust designed to hold ownership of a life insurance policy. Having one can save your estate money on taxes and give you more control over the distribution of a life insurance policy's death benefits. Creating a life insurance trust isn't complicated, but whether you need one in your estate plan depends on your circumstances.

Life insurance trust basics

A life insurance trust, like any trust, must have a creator (known as the grantor), a beneficiary who receives the trust assets upon your death, and a trustee to manage the trust. The trust is generally the primary beneficiary of the life insurance proceeds, and the grantor must name an independent trustee in order to take advantage of estate tax savings, as discussed below.

At the grantor's death, the proceeds are held in trust for the benefit of the beneficiaries. The trustee distributes the proceeds according to the terms of the trust documents, which dictate how, when, and for what purposes distributions are to be made.

Reasons for creating a living trust

One advantage of putting a life insurance policy in a trust is to provide immediate liquidity to your estate upon your death to pay any debts that may be due, including taxes.

The two most common reasons for creating a living trust, though, are the following:

Reduce estate tax liability

If you own your life insurance policy at the time of your death, its value is included in your estate and thus may be subject to estate tax. If estate taxes are a concern, then it is to your advantage to move the policy into a life insurance trust. Taxation of your estate means more of your hard-earned cash will go to the government instead of to your loved ones, and putting your life insurance policy in a trust is one way to avoid that.

Note that only an irrevocable life insurance trust, which generally cannot be modified or canceled (although some states may allow changes), works in this way for estate tax purposes. Accordingly, while a revocable life insurance trust may be an option, you should know that it wouldn't have any effect on estate tax liability.

Control the proceeds

With a life insurance policy not held in a trust, the proceeds are distributed to beneficiaries in one lump sum upon your death. You may not want your beneficiaries to have immediate access to a lump sum of cash for many reasons, though, such as the age or maturity level of the beneficiaries.

Or perhaps your life insurance beneficiary has a high level of debt, and you fear that the proceeds could be subject to creditors. Another consideration is if your intended beneficiary receives government benefits, such as Medicaid, because their receipt of a lump sum of cash could make them ineligible.

With a life insurance trust, you can dictate that the trustee distribute proceeds monthly or annually or even upon reaching milestones such as graduating from college or getting married. You also may limit for what purposes the proceeds may be used. For instance, for a beneficiary who receives Medicaid, you can stipulate that proceeds are not to be distributed for the purposes of food, shelter, or clothing but rather for other reasons (education, entertainment) to help ensure the beneficiary's Medicaid benefits remain intact.

Life insurance trust caveats

If you die within three years of transferring your policy to a life insurance trust, the Internal Revenue Service considers the trust to be invalid, and the value of the policy will be included in your estate.

Another issue is that you or your loved ones could face gift tax concerns relating to what is known as the Crummey withdrawal powers, a topic for which you may want to consult with an attorney or qualified estate planning professional. Also, the trust should make all life insurance policy premium payments rather than having the grantor pay the insurer directly. To accomplish this, the grantor can make cash gifts to the trust to cover the premiums.

As you consider the various aspects of your estate planning needs, you also may seek out an experienced provider of estate planning needs to help you decide whether a life insurance trust should be part of your estate plan.