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What is a life insurance trust?

Death benefits paid on a life insurance policy pass to the beneficiaries of the policy free of income taxes. But life insurance proceeds may be subject to federal estate taxes instead. You can make sure that your life insurance pays your beneficiaries free of both federal estate taxes and income taxes by having your insurance owned by an irrevocable life insurance trust. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Because your irrevocable life insurance trust will be considered the owner of the life insurance upon your death, the value of your life insurance will be excluded from your gross estate. There is one exception to this estate tax-free rule, however. If you transfer the ownership of an existing policy on your life to your irrevocable life insurance trust and you die within three years of the transfer, the entire value of the policy is brought back into your estate for federal estate tax purposes." To guard against such a trap, some financial experts say that you should have the trustee of your irrevocable life insurance trust purchase a new policy on your life so that if you die within three years, the policy is excluded from your estate.

What is an irrevocable trust and what are its tax advantages?

When you create a trust, you decide whether the trust will be revocable or irrevocable. A revocable trust can be changed or even dissolved by you at any time. An irrevocable trust, however, can never be changed. The assets you put into it must stay there. Beneficiaries cannot be added or deleted. And the only way to change the trustee is for that person to die or agree to resign. Why, then, choose to make your trust irrevocable? For tax advantages. An irrevocable trust or the beneficiary of the trust pays the income taxes on what its assets earn. When you die, the trust property is not part of your estate and will not be subject to death taxes. Conversely, revocable trusts offer no tax benefits at all. If you want lots of flexibility, make your trust revocable. But if you want tax breaks, you must forgo flexibility and form an irrevocable trust instead. -- Kenneth J. Strauss

What’s the purpose of establishing an irrevocable life insurance trust?

The aim of an irrevocable ife insurance trust is to keep the death benefits from a life insurance policy outside of the policyholder’s estate -- and thereby remove the chance that the proceeds will be subject to a federal estate tax that can reach as high as 55%. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver, Colo.), "A properly established irrevocable life insurance trust owns life insurance on the life of the trust maker, thereby keeping the life insurance proceeds outside of his or her estate and avoiding federal estate tax (federal income tax is also avoided for different reasons). An irrevocable life insurance trust keeps policy proceeds free of federal estate tax upon the death of the trust maker and also on the subsequent death of his or her spouse. "The proper use of this type of trust allows the trustees to satisfy the trust maker’s estate settlement costs and death tax obligations without subjecting the insurance proceeds to those costs and taxes. By utilizing this planning vehicle, a 50% federal estate tax bracket taxpayer can purchase half as much life insurance as he or she would own personally and still get the same after-tax insurance benefit for his or her beneficiaries. Or he or she could double the amount of the coverage passing to his or her beneficiaries without paying a dime more of premium."

What is the downside of establishing an irrevocable life insurance trust?

While establishing an irrevocable life insurance trust can provide you with several benefits, the trusts have their disadvantages. Some people consider these trusts too complicated and expensive to establish and maintain. They don’t care much about controlling the proceeds from their life insurance policy, even if it means allowing the Internal Revenue Service to keep up to 55% of the money. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Other individuals are concerned about the loss of control over the terms of the irrevocable life insurance trust’s provisions and the inability to use the cash value of the life insurance. These people want to ensure that if tax laws change or their circumstances change, they can exercise some kind of control over the trust and its terms. Although the cost to create and maintain these trusts is but a small fraction of the eventual tax savings that will pass to their children and grandchildren, some people do not feel comfortable using this technique."

How does an irrevocable life insurance trust pay the insurance premium?

Typically, the premiums for life insurance held by an irrevocable life insurance trust are paid from annual gifts made to the trust by the person who establishes it. Crummey demand powers are used to preserve the tax-free gift exclusion for gifts of a present interest up to $10,000 per beneficiary.

Who should I pick as the trustee of my irrevocable life insurance trust?

When you’re deciding whom to name as the trustee of your irrevocable life insurance trust, you should automatically scratch both your name and the name of your spouse from the list. According to "Wealth Enhancement and Preservation" (The Institute Inc., Denver, Colo.), "It is very clear under tax law that you should not be the trustee of an irrevocable life insurance trust that you set up. The trustee probably should not be your spouse either. Many planners suggest that a good trustee for an irrevocable life insurance trust might be the local bank trust department. Bank trust departments deal with irrevocable trusts on a regular basis, as do accountants. Because of the technical nature involved in the administration of an irrevocable life insurance trust, it may not be a good idea to use individuals as your trustees unless they are extremely well versed and competent to handle the technicalities involved."

What is a Crummey trust?

A Crummey trust is a type of irrevocable life insurance trust that allows the trust’s beneficiaries to demand that the trustee pay them their share of the monies contributed to the trust within a specified period. The name comes from D. Clifford Crummey, whose court case resulted in the approval of the demand right technique. Those rights, called Crummey rights or Crummey power, have since been expanded to beneficiaries of many other types of trusts as well. Premiums must be paid on the life insurnace in the trust. Typically the grantor makes gifts to the trust of up to $10,000 per beneficiary. However, these gifts must be gifts of a present interest or the $10,000 gift exclusion will not apply. The Crummey power solves this problem.

What is Crummey demand power and how does it affect gift taxes?

Crummey demand power is an important tool in planning gift taxes. This power permits all transfers to a trust to qualify for the $10,000 gift tax exclusion even if the trust benefits are delayed into the future. The term "Crummey" comes from E. Clifford Crummey, whose court case resulted in the approval of the demand right technique.

How are the death proceeds paid to an irrevocable life insurance trust used by an estate to pay death taxes?

When the death benefits from an insurance policy are paid to an irrevocable life insurance trust, the estate itself can access the money to pay death taxes in one of two ways. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), the trustees of the trust can lend the proceeds to the estate and take back a promissory note. In a better alternative, the trustees can buy assets from the estate and own those non-liquid assets in the irrevocable life insurance trust.

How do I transfer my group life insurance policy to an irrevocable life insurance trust in order to avoid estate taxes?

Many workers have a group life insurance policy through their employer. By placing these policies in an irrevocable life insurance trust, you can keep the proceeds out of your estate when you die and thus guarantee that the benefits will be free from the federal estate tax than can top 50%. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver, Colo.), "The transfer is made by preparing an assignment which irrevocably assigns all your rights under the group policy to your irrevocable trust. This would include your rights to ownership, your rights to change the beneficiaries, and your rights to convert the policy to a permanent form of insurance. This change of ownership should be documented and forwarded to the insurance company for its acknowledgment. The insurance company may have a form that is appropriate for your use. "However, it may be necessary to use your attorney. If any identification documentation is required (i.e. ownership certificates, etc.), this documentation should be reissued by the insurance company in the name of the irrevocable trust. "Some group policies include provisions prohibiting assignment of employees’ rights. If you find yourself in this situation, you should contact the insurance company and ask that it waive this prohibition; this usually requires the written consent of the insurance company and your employer."

Is there a way to have access to the cash value of life insurance owned in an irrevocable life insurance trust?

The cash value of a life insurance policy held within an irrevocable life insurance trust generally can’t be touched. But using a special "split-dollar" arrangement can make the cash accessible. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver, Colo.), "A significant problem with purchasing life insurance in an irrevocable trust is that the cash value of the life insurance owned by the trust will be outside the reach of the trust maker during his or her lifetime. "A family split-dollar arrangement structures the ownership of the life insurance policy so that the insurance coverage is owned and held by the irrevocable life insurance trust, and the cash value or investment component of the policy is held separately by the trust maker’s spouse without causing the insurance death benefit to be included in the maker’s estate for federal estate tax planning purposes."