November 22, 2017

Irrevocable Life Insurance Trust

In the United States, proper ownership of life insurance is important if the insurance proceeds are to escape federal estate taxation. If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.) To avoid estate taxation, some insureds name a child, spouse or other beneficiary as the owner of the policy.

There are, however, two drawbacks to having insurance proceeds paid outright to a child, spouse or other beneficiary.

  • Doing so may be inconsistent with the insured’s wishes or the best interests of the beneficiary, who might be a minor or lacking in financial sophistication and unable to invest the proceeds wisely.
  • The insurance proceeds will be included in the beneficiary’s taxable estate at his or her subsequent death. If the proceeds are used to pay the insured’s estate taxes, it would at first appear that the proceeds could not be on hand to be taxed at the beneficiary’s subsequent death. However, using insurance proceeds to pay the insured’s estate taxes effectively increases the beneficiary’s estate since the beneficiary will not have to sell inherited assets to pay such taxes.

The solution to both drawbacks is usually an irrevocable life insurance trust.

A life insurance trust is an irrevocable, non-amendable trust which is both the owner and beneficiary of one or more life insurance policies. Upon the death of the insured, the Trustee invests the insurance proceeds and administers the trust for one or more beneficiaries. If the trust owns insurance on the life of a married person, the non-insured spouse and children are often beneficiaries of the insurance trust. If the trust owns “second to die” or survivorship insurance which only pays when both spouses are deceased, only the children would be beneficiaries of the insurance trust.