If you are single and your net estate, including life insurance, is more than the federal estate tax exemption, or if you are married and your total net estate is more than two exemptions, an irrevocable life insurance trust can reduce your estate taxes.
Life insurance proceeds for which you have any “incidents of ownership” (policies you can borrow against, assign, or cancel, or for which you can revoke an assignment, or name or change the beneficiary) are included in your taxable estate when you die. Currently, every dollar over the federal exemption is taxed at 40%.
Very simply, a life insurance trust owns your insurance policies for you. And because you don’t personally own the insurance, it will not be included in your taxable estate. This makes your estate smaller—so it will pay less in estate taxes and more of your estate will go to your family.
Alternately, you could have another person (like your spouse or an adult child) own your insurance for you. That would keep it out of your estate but you would not have as much control over the policy. This person could change the beneficiary, take the cash value, or even cancel the policy. With an insurance trust, the trustee you select (it must be someone other than you) must follow the instructions in your trust.
An insurance trust also gives you more control over how the proceeds are used. For example, you could direct the trustee to make the funds available to pay taxes and other final expenses. You could provide your surviving spouse with a lifetime income and keep the proceeds out of both of your estates. You could also keep the proceeds in trust and provide periodic income to your children or other loved ones—without giving them the full amount.
Existing policies can be transferred into an insurance trust, but if you die within three years of making the transfer, the death benefits of the policies will be taxed as part of your estate. There may also be a gift tax.
The trustee can also purchase a new policy, but it must be done in a special way so you don’t incur a gift tax. Each year, you can make an annual tax-free gift to each beneficiary of the insurance trust. But instead of giving this money directly to the beneficiaries, you give it to the trustee for them.
The trustee then notifies each beneficiary that a gift has been received on his/her behalf and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds—by paying the premium on the insurance policy. Of course, for this to work, the beneficiaries must understand not to take the gift now. (By the way, the written notification to the beneficiaries is known as a “Crummey letter,” named after the man who first tested it with the IRS.)