Insurance Trusts

The Need for Life Insurance

When a person passes away, the survivors need a source of funds to pay for last medical bills, funeral costs, support for the survivors, and often estate taxes. However, many people may have substantial wealth in illiquid assets, such as closely-held businesses, their home or other real estate. Under current tax law, if a person’s net estate exceeds the estate tax exclusion ($2,000,000 in 2006-2008, but then back down to $1,000,000 in 2011), estate taxes (federal and state) must be paid. We will assume the $1,000,000 estate tax exemption is in effect under the examples below. The estate taxes are very expensive – they start at 41% and quickly go up to 49%, depending on the size of the estate.

In addition, these estate taxes are due nine months after death – in cash. This can devastate many estates (especially those with small businesses or other illiquid assets). Such assets must often be liquidated instead of being preserved for the heirs.

On the other hand, to avoid forced sales, people often buy life insurance. However, if the insured owns the policy, the proceeds themselves will be subject to estate taxes. The net proceeds, after payment of estate taxes, will often only be half of the proceeds paid under the policy. For example, a $500,000 policy owned by the insured will often generate a $210,000 estate tax attributable solely to the insurance proceeds. Thus, only $290,000 of the proceeds will be available to the beneficiaries.

Surprisingly, through the use of a relatively simple and properly drafted life insurance trust, the insurance proceeds will not be subject to estate taxes. The full proceeds will be available to the beneficiaries, free of both estate and income taxes.

Who Needs a Life Insurance Trust?

If you are single and have a net worth over $1,000,000 (including life insurance proceeds upon death), or if you are married and have a net worth over $2.0 million (again, including life insurance), you should seriously consider a life insurance trust. Let us consider an example:

Let us say you are single, with a total net worth of $1,000,000. In addition, you own a $500,000 life insurance policy – a total estate of $1,500,000. Without a life insurance trust, the $500,000 of life insurance would be included in your taxable estate – and your estate would have to pay $210,000 in estate taxes.

On the other hand, if your $500,000 policy were instead owned by your life insurance trust, the $500,000 in insurance would not be included in your estate. Because your other assets would equal the $1,000,000 estate tax exemption ($1,500,000 in 2003 and 2004, back down to $1,000,000 in 2011), no estate taxes would be due. That means that $210,000 would go to your beneficiaries, instead of to Uncle Sam.

Without Life Insurance Trust With Life Insurance Trust

$1,000,000 Net Worth $1,000,000 Net Worth
500,000 Insurance you own 500,000 Insurance you own
$1,500,000 Net Estate $1,000,000 Net Estate
210,000 Federal Estate Taxes 00 Federal Estate Taxes
$1,290,000 Balance $1,000,000 Balance
00 Insurance Trust 500,000 Insurance Trust
$1,290,000 Assets to Beneficiaries $1,500,000 Assets to Beneficiaries

Why Use a Life Insurance Trust?

There are several very good reasons for using a life insurance trust. First, by purchasing the insurance through a life insurance trust, as you have seen, it is excluded from your taxable estate. Hence, the proceeds, which are already free from probate and income taxes, will also be free from estate taxes. Second, life insurance proceeds are available immediately, even if you die tomorrow. Therefore, you would not have to worry about your estate having to be quickly liquidated at fire sale prices to pay estate taxes.

Could Not My Spouse Own My Insurance Instead of Using a Trust?

You could, but if your spouse dies first, the cash (or termination) value of the policy would be included in his or her taxable estate. Even if your spouse survives you, when your spouse subsequently dies, any remaining insurance proceeds would be included in his or her estate. Thus, life insurance you own only worsens the estate tax problem. By using a life insurance trust, the insurance proceeds are kept out of both spouses’ estates.

Could Not My Heirs Own My Insurance Instead of Using a Trust?

If you made one or all of your heirs the owners of the policy, you would be taking many risks. If you have several heirs, it is cumbersome to make gifts to all and then for all of them to get together to pay the insurance premiums. However, if you only name one heir for simplicity’s sake, you risk that one heir refusing to share the proceeds with the others when you die. Also, sharing the proceeds very well could be a taxable gift on his or her part. Furthermore, before you die, if your heirs own the policy, they could cash it in any time and frustrate the purpose of the policy – to pay the estate taxes.

Probably worst of all, if your heir had financial problems, such as an IRS problem or a bankruptcy, the insurance would be seized by his or her creditors. You probably trust this person now, but you never know what problems may crop up later.

On the other hand, an insurance trust is a safer alternative. You would still name the same one or more heirs as the trustee(s) to take out the policy and run the trust (generally the same as the successor trustee(s) under your living trust). However, the trustees would have a duty to act properly and could not change who would get the money in the end. Moreover, if any trustee had financial problems, their creditors could not touch the insurance trust assets. Therefore, the insurance trust allows you to better assure that your intent is carried out.

Are There Other Reasons Why the Trust Should Be the Beneficiary of the Policy?

Yes. Besides keeping control of the proceeds, you prevent a possible conservatorship or guardianship if one of your trust beneficiaries is incompetent or a minor when you die. Generally, an insurance company will not pay proceeds directly to an incompetent or minor, insisting instead on court supervision. If your trust is the insurance beneficiary, the trustee will receive the proceeds and provide for this person’s care for as long as needed.

Can I Transfer My Existing Policies to the Trust?

Yes, but if you die within three years of the date of the transfer, the insurance proceeds will still be included in your gross estate, despite the trust. There may also be gift tax consequences. However, it is usually best to go ahead and make the transfer now. If you have existing policies, we will be happy to discuss this with you.

Can I Make Changes to the Trust?

Unfortunately, once the trust is signed, you cannot make any changes. The trust is irrevocable. Therefore, it is very important that you understand the trust, and make sure that it is exactly what you want before you sign it.

How Does a Life Insurance Trust Work?

A life insurance trust has three components. First, you are the grantor (also called the settlor or trustor) and create the trust. Second, there is the insurance trust itself, which is managed by the trustee you select. Third, there are the beneficiaries you select who will receive the trust assets when you are gone.

With a new policy, the trustee applies for the life insurance policy. You are the insured, and the trust is the owner of the policy. Also, you may assign an existing policy to the trust. In either case, you give the money to the trust to make the premiums. (This is discussed in more detail below.)

The trust is the beneficiary of the policy. After your death, the trustee will collect the proceeds and distribute them as you have instructed in the trust instrument. The following illustrates the above:


Cash for Insurance



(Insurance Policy)

Insurance Proceeds



Who Can Be Beneficiaries of the Insurance Trust?

Most people name their children, but you can name anyone you wish, as a beneficiary of your insurance trust. The funds can be used to pay estate taxes or for other purposes – for example, you may want to provide for your children’s or grandchildren’s education.

Can I Be My Own Trustee?

Not if you want the tax advantages mentioned above. If you are the trustee, the trust is taxed by the estate tax. You must name another person as trustee. The trustee can be anyone you choose, such as an heir, a friend, or a professional trustee.

Where Does the Trustee Get the Money to Purchase the Insurance?

The trustee gets the money from you, but in a special way. If you give the money directly to the insurance company, it could be subject to a gift tax. You also want to make sure you avoid any “incidents of ownership.” So here is what you can do:

Each year, you can gift up to $11,000 to each beneficiary of your trust with no gift tax. (If you are married, you and your spouse together can gift up to $22,000 per beneficiary.) However, instead of making the gift directly to the beneficiaries, you give it to the trustee. The trustee then notifies each trust beneficiary that a gift has been received on his or her behalf and, unless he or she elects to withdraw the gift now, the trustee will invest the funds – by paying the premium on the insurance policy. Of course, for this to work properly, the beneficiaries must understand not to withdraw the gift now but to wait for the insurance proceeds.

What are the Disadvantages of Life Insurance Trusts?

The only disadvantage of a life insurance trust is that you cannot personally own the policy. If you want the tax advantages of a life insurance trust, you cannot have any “incidents of ownership” of the policy. The tax laws define “incidents of ownership” as:

1. the right to have the proceeds made payable to your estate;

2. the power to change the beneficiary;

3. the power to surrender or cancel the policy;

4. the power to assign the policy;

5. the power to revoke an assignment;

6. the power to pledge the policy for a loan;

7. the power to borrow against the surrender value of the policy;

8. the power to veto a change in beneficiary or an assignment or cancellation of the policy; or

9. the existence of a reversionary interest in the policy or its proceeds that immediately before death exceeds 5 percent of the value of the policy.

Because the life insurance trust will own the policy, all of these rights and powers will be owned by the trust itself and controlled by the trustee you have selected, instead of you. Because of this, the proceeds will not be included in your estate for tax purposes.

However, although you do not own the policy, the proceeds will still be distributed as you wish. When the trust is established, you will state in the trust how the proceeds are to be distributed when they are received after your death. The trustee you select must follow these instructions. According to your desires, the trustee can use the proceeds to purchase assets from your living trust to provide cash to pay taxes. Alternatively, the trustee can be directed to hold the funds and disburse them to the beneficiaries you have selected for their support. (In contrast, if your children are the direct beneficiaries of your insurance, you cannot control how they use the proceeds.)

Although you do lose some rights in the policy, if the trust is properly drafted according to your desires, such loss is far outweighed by the tremendous tax savings.

What If I Believe Life Insurance Is Not The Greatest Investment?

We are not investment advisers. However, at a time early in our careers we thought permanent life insurance was a less than good investment. We now have completely changed our minds because of our experiences with clients. Because life insurance in an insurance trust pays out free of both income and estate taxes, it must be seriously considered as the best investment for many people as far as the net dollars in the end that will go to the heirs. This is something we would be glad to discuss with you.

Notwithstanding, we do not sell insurance. However, if you would like us to, we can refer you to life insurance advisers.

How Can I Find Out More?

To learn more about life insurance trusts, or if you would like a free consultation to learn if an insurance trust is right for you, please do not hesitate to contact us at (805) 482-2282, or e-mail us at


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