What is a Life Insurance Trust?

Most people are familiar with the basic concept of life insurance planning, yet a life insurance trust may not be as familiar. A life insurance trust involves one or more life insurance policies, but it is not a life insurance product itself. 

While life insurance trusts are not for everyone, they have distinct advantages for the right purpose. 

What is a Life Insurance Trust?

A life insurance trust, also known as an irrevocable life insurance trust or ILIT, is a specific type of trust you fund for your lifetime. It includes one or more life insurance policies and cannot be changed once it has been created. Moreover, it cannot be revoked.

As with any trust, a life insurance trust involves the following three parties:

1. Grantor: the person who sets up the trust and adds their assets to it 
2. Beneficiary: one or more people who receive some of the trust’s assets 
3. Trustee: a third-party who manages the trust 

The terms of a life insurance trust stand firm no matter how your life circumstances change. The idea of having a trust with no flexibility and no ability to change it might make you a bit uneasy. The lack of flexibility means that a life insurance trust is not right for every person or every circumstance, but certain circumstances make having one worthwhile. 

To gain a better understanding of why someone would choose an ILIT, Benzinga will look at a few types of situations where it makes sense to create one. 

If you are parenting a child who has special needs because of a physical disability or mental health disorder, and you want to make sure they have financial means after you die, a life insurance trust would fund the child’s income without reducing their eligibility for disability benefits or Social Security. 

An ILIT can also be used to support an adult child who cannot manage their finances responsibly. Parents who expect to leave their minor child an inheritance may also benefit by creating a life insurance trust. 

Life insurance trusts can also be used to protect businesses by providing funds to continue operating a business after a principal partner dies until a succession plan is in place. If there are multiple beneficiaries to a life insurance policy such as entities, siblings or business partners, an ILIT will ensure an equitable distribution of the death benefit. 

These scenarios demonstrate why an ILIT can be a valuable financial tool for individuals who want to direct their financial legacy. A life insurance trust can be used to satisfy several estate planning goals as well as ensure your loved ones have financial support after you die and possibly for future generations to come. 

One of the great things about life insurance trusts is they are easy to create and maintain. The funds will be deposited into a single bank account and the premiums will be paid from the same bank account. 

 Benefits of a Life Insurance Trust

The six distinct benefits of a life insurance trust include:

1. It cannot be changed or revoked. There are two kinds of trusts: A revocable trust can be amended, and an irrevocable trust cannot be changed. Once an irrevocable life insurance trust has been created, you do not have to touch it again.
2. The death benefits would be excluded from your estate for tax purposes. A life insurance trust allows you to direct who the death benefit goes to, when they can access it and how they can use it. 
3. ILITs carry distinct tax advantages. Beneficiaries may not have to pay estate, gift or inheritance taxes on the death benefit. 
4. It provides a means to protect the inheritances of minor children or other dependents who need financial protection. It gives you peace of mind in knowing your loved ones will have the proper financial support after your death. 
5. It provides liquidity for the succession of a business. An ILIT can be created to cover a buy-sell agreement and provide liquidity if one of the partners dies.
6. It offers protection from creditors. Life insurance policies are subject to creditors after a policyholder dies. For the assets involved in an ILIT, creditors will not be able to make a claim against the funds. 

Divorce lawyers sometimes recommend setting up an ILIT for the wealthier spouse to fund child support or alimony upon their death. Rather than take out a standard life insurance policy where the ex-spouse has the power to direct the proceeds as they see fit, an ILIT could give the ex-spouse interest only until they remarry, cohabitate or die. At that point, the benefits of the trust would freely pass down to the children or other beneficiaries.

Be aware that the grantor would not be able to take the alimony tax deduction for the insurance premiums; however, they might feel this is a small price to pay for being able to direct the proceeds of the death benefit. 

In general, ILITs give beneficiaries the benefit of liquidity during the time an estate is being settled. Death benefit funds can also provide income for beneficiaries once liquidity costs have been settled. Also, if executors’ fees are determined by a percentage of the estate value, an ILIT can reduce the executors’ fees overall. Another benefit is an ILIT can keep the provisions of a trust confidential and hidden from the public record. 

Drawbacks of a Life Insurance Trust

The primary drawback of a life insurance trust is you lose control over the funds once it has been created. 

Another disadvantage is an ILIT does not apply to many people because the federal tax exemption rate is so high. For that reason, they only make sense for the wealthiest of people.

One other thing to consider is there are costs involved in establishing and maintaining a life insurance trust. You may have to pay a gift tax the year you create the trust and possibly in the coming years, depending on how the trust was set up.  

Final Thoughts on Life Insurance Trusts

The main reason for considering an ILIT is to reduce estate and gift taxes. Overall, the benefits of life insurance trusts outweigh the disadvantages when they are created for an appropriate purpose. Something else to consider is that the regulations over life insurance trusts are subject to the IRS, the political climate and court rulings, so it is important to keep up on regulatory changes that could affect your life insurance trust. 

Frequently Asked Questions