About Life Insurance Trusts

Life insurance trusts can be very useful for those planning on leaving large sums of money to others when they pass away. They can be a way to avoid estate tax if done properly, but there are several things that should be considered before setting up such a plan. Find out more and learn some information that will help keep the IRS from taking action.

Function

Life insurance trusts are set up so that someone is the owner of the life insurance policy. In general they are set up so that someone other than the insured is the owner. Normally, it is stated in the paperwork that the trust itself is the owner of the policy, and beneficiaries will get their funds from the trust in the event of the insured person's death.

Benefits

If an insurance policy is owned by the insurer, then the funds that are given out in the event of his death are hit with an estate tax. If, however, the policy is set up under a life insurance trust, then the funds are not subject to the estate tax. This is a huge tax savings benefit since estate tax can sometimes run close to 50 percent.

Considerations

What the insured must consider before going through with this set up is that he will not be able to borrow against the life insurance policy after it is set up under the trust. If the trust is set up to allow the insured to borrow, then he would still be considered the owner and the policy would be taxed with the estate tax.

The insured will no longer own the policy. And as such will not be able to change the beneficiary information after the policy is set up. The trust will be the beneficiary. The insured will designate the beneficiaries of the trust when it is first set up, but will not be able to change them in the future. This should be considered if the insured feels that there might be family issues that could change the needs of the trust.

Time Frame

There is a three-year time constraint that can change the status of the trust. After a trust is set up the insured must stay alive for three years. If the insured dies before the trust has been in existence for three years, then the insured will be considered as the owner of the policy and the funds will be to estate tax laws.

Prevention/Solution

The IRS does not like life insurance trusts and as such have fought them in court. On occasion the IRS has won these suits mainly because the trusts were not set up adequately. However, there are ways to avoid some of the reasons that others have lost their suits. First is to make sure the insured never owns the life insurance policy to begin with. Set up the trust first and then let the trust take out the policy on the individual. By doing it this way there is no paperwork that can ever be linked to the insured as the owner. Next, have the life insurance set up as just one of many ways for the trust to create funds for the trustees, instead of telling the trustees directly to take out a life insurance policy. This way it is the trustee's choice to take out the policy instead of a direct order from the insured. Last, make sure that the trust is worded in such a way that will give the insured the means to give tax-free gifts to the trust to pay for the insurance premiums. This will keep the burden of the premiums off of the trust. If it isn't worded correctly, it might be construed by the IRS that the insured is indeed the owner of the policy.

Warning

Once the trust is set up, the policy is out of the insured individual's hands and cannot be changed. If for some reason the insured became a health risk to the point where he could no longer get life insurance, then this trust would be his only life insurance. Since the insured would not be able to change the beneficiaries of the trust policy, then he would not be able to add any new beneficiaries that might come about in the future.