The Irrevocable Life Insurance Trust

An irrevocable life insurance trust allows you to reduce or eliminate estate taxes so that you can pass more of your estate to loved ones. For a single individual whose net estate, including life insurance, exceeds the estate tax exemption ($1,000,000 in 2002 and 2003) and a married couple whose net estate exceeds both spouse’s exemptions ($2,000,000 in 2002 and 2003), an irrevocable life insurance trust should be considered. In 2002, estate taxes start at 41% and increase to a peak of 50%. For an estate valued at $2,500,000 (of which $500,000 is life insurance), a revocable AB living trust can protect $2,000,000 from estate taxes. Assuming the life insurance is owned by the deceased person, it would be included in the couple’s estate and would be subject to estate taxes. In 2002, the estate taxes would approximate $200,000 on a $500,000 policy. If the couple were to utilize an irrevocable life insurance trust to own the policy, the life insurance proceeds would be removed from the couple’s estate and avoid estate taxes. Very simply, an irrevocable life insurance trust owns a person’s insurance policy for him or her. As a result, the policy will not be included in the person’s taxable estate at death. This means the estate will pay less in estate taxes, and family will benefit from wealth preservation.

If a couple’s estate is much larger than the foregoing example, they can purchase additional life insurance to reduce estate taxes. The benefits of additional life insurance include the exclusion of the policies from the deceased person’s estate at death, the availability of proceeds immediately after death, and the avoidance of having to liquidate assets to pay estate taxes (estate taxes are due 9 months after the date of death and must be paid in cash). Additionally, life insurance is inexpensive relative to the cost of having to pay estate taxes.

The irrevocable life insurance trust works like this. You set up an irrevocable life insurance trust and name a trustee other than yourself (i.e., bank, corporate trustee, adult children). The trustee purchases a life insurance policy in the name of the trust with you as the named insured. You name your revocable living trust as the beneficiary of the policy. When you pass on, the life insurance proceeds are paid to the trustee, who then uses it to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits). The proceeds are then distributed by the trustee to the beneficiaries named in your trust. As mentioned, the proceeds will not be included in your estate when calculating estate taxes that may become due because the policy is owned by the trust and not by you. The irrevocable life insurance trust gives you control over how the proceeds are to be used since the trustee that you name will distribute the proceeds according to the instructions set forth by you in the irrevocable life insurance trust.

You may be asking whether the same objective can be accomplished by naming a child or spouse as the owner of the policy. You can. However, the problem with doing so is that your spouse or child will have control over how the life insurance proceeds are spent. With a revocable living trust, you determine how the proceeds are spent. For example, you could instruct the trustee to keep the proceeds in the trust while making periodic distributions to your spouse or child during their lifetimes.

You will also note that the above example recommends that your revocable living trust be named as the beneficiary of life insurance policy. There is good reason for this. If you name a child or spouse as the beneficiary and either your child or spouse predecease you, the insurance proceeds would be payable to either your child’s or spouse’s estate, which would be subject to probate before distribution could occur. In such instance, you would also lose control over how the proceeds are to be spent.

The trustee of the irrevocable life insurance trust must be careful when purchasing the insurance policy so as not to incur a gift tax. Making use of the annual gift tax exemption of $11,000 ($22,000 for a married couple) to one or more beneficiaries of the irrevocable trust can accomplish this. How it works is you pay to the trustee for the benefit of each beneficiary of the trust up to $11,000 ($22,000 for married couples). The trustee advises the beneficiaries (your children) in writing that you (and your spouse) have made a gift to them. This written letter is known as a “crummy” letter. Legally, the beneficiaries can withdraw their share and use the funds for whatever they desire. However, it is in their best interest not to do so. The trustee then reinvests the gifted funds to pay for the insurance premiums.

You can also transfer existing life insurance policies into an irrevocable life insurance trust, but if you die within three years of the date of the transfer, the life insurance proceeds will be taxed as part of your estate. The transfer may also subject you to a gift tax since the beneficiaries of the trust would be receiving policies with a value in excess of the annual gift tax exemption.