Can I put life insurance inside a trust?

Yes, you can put your life insurance policy inside a trust, although it’s generally better to have the trustee buy the policy (as a trustee of the trust) to make sure the life insurance policy is immediately exempt from your estate for estate tax purposes if you plan on using an irrevocable trust (as opposed to a revocable trust).

You should also be aware that if you transfer an existing policy to an irrevocable trust, then you’ll have to get beyond the 3-year lookback period to ensure the life insurance proceeds won’t be included in your estate for estate tax purposes. And if the policy has a cash balance then you have the extra complication of whether it would exceed the annual gift tax exclusion and therefore subtract from the lifetime gift tax exemption (which would decrease your estate tax exemption threshold because the estate tax exemption takes into account gifts made during your lifetime).

Does my trust have to be irrevocable? What does that mean?

If you intend for your life insurance proceeds to not be part of your estate for estate tax purposes, then the life insurance trust must be irrevocable and you cannot have any “incidents of ownership” over the policy. This means you cannot be a trustee of that trust and cannot reserve any powers or control over the policy (e.g., can’t change the beneficiaries, can’t borrow against the cash value, cannot assign the policy, etc.).

Since the trust is irrevocable, once it’s created it generally cannot be modified - so you’ll want to make sure you set it up correctly from the start and understand exactly what you are doing before you pursue this strategy.

But I thought life insurance was tax free?

Life insurance proceeds are not subject to income taxes, but they can be subject to estate taxes (and generation skipping transfer taxes) if you don’t have a proper estate plan in place.

Some states do not have an estate or inheritance tax, but other states (like Massachusetts) do have an estate tax if your estate exceeds $2 million. So even if you fall below the current federal estate tax exemption threshold, you should be aware of whether your property may be subject to a state’s estate tax.

Can my spouse be a trustee of my life insurance trust?

I generally don’t recommend naming your spouse as a trustee (and you cannot name a spouse as the trustee if you have a second-to-die policy in the trust). The reason being that if you accidentally transfer money to your trust from a joint account held by you and your spouse then you have have inadvertently made a substantial portion of those life insurance benefits a part of the spouse’s estate for estate tax purposes (and the goal here is to make sure the life insurance proceeds are not includable in either spouse’s estate for estate tax purposes). 

In addition to that complication, if you have minor beneficiaries in the trust and have given them something called a withdrawal right (to make sure that the transfer to the trust is a present interest gift that qualifies for the annual gift tax exclusion) then your spouse may be signing as the trustee (providing notice) and the natural guardian of the child (receiving notice) which would create a conflict of interest and I wouldn’t want to test that theory of whether that’s acceptable in the tax court. Similarly, if your spouse is a beneficiary of the trust with the same withdrawal right, then you stumble upon the same complication.

With that being said, if the trust is funded with a single life policy (payable on your death) and if the trustee’s right are limited to an ascertainable standard (e.g., reasonable health, education, maintenance, and support payments allowed) then it should be fine for your spouse to step in as the trustee after your death.

In the meantime, we recommend having a professional (could be your tax accountant or attorney) or a responsible family member (who is not a beneficiary of the trust) or a close friend to serve as the trustee to make sure premiums are paid and withdrawal right notices are given at the right time for the duration of your life.

What are withdrawal rights?

This is where things get confusing for a lot of people. In order for you to make sure the the premiums on the policy are paid in a timely manner, you need to put money in the trust (you can’t pay the premiums directly because that may be considered a non-exempt gift to the trust and/or be a sign of retaining control over the policy), so instead you simply transfer money into the trust checking account.

But in order for that transfer to the trust to qualify for the annual gift tax exclusion (and therefore not eat away at your lifetime gift exemption), it needs to be a “present interest” gift. The way you make the gift a present interest gift is by giving the beneficiaries of the trust the ability to immediately withdraw funds from the trust. 

To prove that the beneficiaries were aware that such money was transferred to the trust and that the beneficiaries are aware of their right to pull the money from the trust, we have these letters called withdrawal notices (referred to as Crummey withdrawal notices because of the case named after the Crummey family - yes, that’s their real last name). 

The best practice for proper administration of an irrevocable life insurance trust is to put the money in the trust 30-45 days prior to the premium payment being paid and simultaneously provide notice to the beneficiaries of their right to withdraw money from the trust. Usually this withdrawal right lasts about 30 days which is generally seen as a sufficient amount of time to allow such withdrawal to take place. The beneficiary generally doesn’t withdraw such money because it’s in their best interest not to do so, and then the trustee of the trust uses that money to make the premium payments.

There is some additional technicality over whether the full withdrawal right lapses in 30 days depending on the amount of money transferred to the trust and the number of beneficiaries with withdrawal rights, but your attorney will draft “hanging powers” into the trust to alleviate that concern.

For all the above reasons, you’ll want to make sure your attorney knows what they are doing when they help you create and fund this type of trust - otherwise you can easily waste a bunch of money, time, and effort doing something that doesn’t work as intended.

Who would want an irrevocable life insurance trust (ILIT)?

Any family that is concerned about paying estate taxes may want to consider whether an irrevocable life insurance trust would work given their family dynamics. In addition, any family whose wealth is concentrated in an asset (e.g., privately held business or real estate) that would be hard to sell quickly at market rate (e.g., illiquid assets) or would prefer not to sell in a short time window may benefit greatly from having a properly structured irrevocable life insurance trust in place.

Questions or concerns? I’m always happy to help - you can schedule a call with me through the link below. Thank you.