Life insurance trusts are a great way to avoid a windfall of cash hitting your estate when you die, potentially pushing its value over the federal estate tax exemption and bringing estate taxes due. Life insurance trusts are irrevocable, however. Once you create one, you can't undo it – there's no turning back. Therefore, setting up such a trust involves long-term decisions and ongoing requirements.
Transferring a Policy
If you already have a life insurance policy, you can establish an irrevocable trust and transfer ownership of the policy to it. Depending on your age and the value of your policy, this can be a better alternative than surrendering the policy and having your trust purchase a new one. You must outlive the transfer by at least three years if you elect this option. Otherwise, the Internal Revenue Service will treat the transfer as though it never happened. The IRS considers that transfers made within three years of death are done "in contemplation" of death, and it will pull the death benefits back into your estate for tax purposes, just as though you had never created the trust at all. If you're in your thirties, it’s probably worth rolling the dice and setting up your trust this way, but your 80-year-old grandparent might think twice about the option.
Gift Tax Implications
If you transfer an existing policy to your trust, this creates another consideration – the gift tax. If the policy's cash value is more than the annual gift tax exemption – $14,000 as of 2013 – you'll be taxed on the balance over that amount. You don't have to pay the tax immediately, however. You can defer it and let your estate deal with it when you die. The good news is that your estate probably won't have to pay the gift tax either. As of 2013, the IRS offers a $5.25 million unified tax credit. The total of all your lifetime gifts over $14,000, plus the value of your estate, would have to exceed this amount before any taxes would come due.
Purchasing a Policy
If you don't already own a life insurance policy but you want to fund a trust with one, you can let your trust purchase the policy. After you establish your trust and select a trustee, the trustee can apply for and buy the policy. Because your life insurance trust is irrevocable, you can't act as trustee, at least not if your goal is to escape estate taxes on the insurance proceeds. Acting as trustee gives you control over the policy and implies "incidents of ownership," and this is a no-no in the eyes of the IRS. Having your trustee purchase the policy avoids the three-year rule, and you can also sidestep any gift tax considerations.
Paying the Premiums
Whether you fund your trust with an existing policy or you have your trustee purchase a new one, you'll face the problem of ongoing premiums. You can give your trust enough money to pay the premiums as they come due, but this money would also constitute a gift where the IRS is concerned. If the premiums are more than the annual gift tax exemption of $14,000, you can get around the problem setting your trust up to include Crummey language. This requires some expertise, so you'll probably need a professional to draft your trust documents for you. If you do so, however, your trustee can follow a certain procedure each time you give the trust money to pay the premiums. The procedure gives your beneficiaries the right to ask that the money be turned over to them instead – which is obviously not in their best interest because the eventual death benefits will be more than the premiums. As long as your trustee makes the offer, however, you can give money to your trust as often as you like without worrying about a gift tax.
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