Currently, the federal estate tax exemption is $11.58 million. This means that someone can gift this amount of money over the course of their lifetime before taxes on these transactions begin. Once a person exceeds this amount, the IRS is able to keep up to 40 percent of the remaining assets. For many middle to upper-class families, life insurance policies make up a considerable portion of their estate. While most families will not have to worry about exceeding the federal estate tax, the current estate tax exemption could change as soon as 2026.

Prior to the change in 2017, the federal estate tax exemption limit was $5 million. Furthermore, most states have their own inheritance tax exemption limit and it is typically much lower than the federal threshold. Thus, using a life insurance trust to hold your life insurance policy is an extremely useful tool even if you are currently not close to the federal estate tax exemption amount.

What is a Life Insurance Trust

A life insurance trust is a type of irrevocable trust funded solely by a life insurance policy. The reason why life insurance trusts offer benefits is that if you place your life insurance policy in this trust, the trust will own the policy. There are two ways to fund a life insurance trust.

First, one can transfer ownership of an existing life insurance policy into a life insurance trust. However, if this is how one chooses to fund their life insurance policy, the policy must be in the account for at least three years before the trust will be considered to own the insurance policy. Thus, if you create a life insurance trust and place an existing life insurance policy into the trust, yet the person who the trust is for dies within 3 years, the life insurance policy will be subject to the federal estate tax. The other way to fund this trust is to create the trust and have the trustee purchase the insurance policy for the individual. In this scenario, the life insurance policy automatically receives the tax benefits of being in the trust.

A life insurance trust is technically irrevocable, although this account requires one to pay monthly premiums. Thus, if you no longer want the trust with the same policy or you want different beneficiaries to the trust, you could simply stop making payments on the premiums. Finally, while the trust would still exist, it would have no value as the asset meant to fund the trust no longer exists.  

How Does a Life Insurance Trust Work

A life insurance trust consists of three parts. The grantor, the person who funds the account and is insured by the life insurance policy. The beneficiary, the person who will receive the life insurance payout once the grantor passes away. Finally, the trustee is the person who will oversee, manage, and distribute the assets within the trust. Once the insurance policy is in the trust, the trustee will pay the premiums each month. Furthermore, when the insured individual passes away, the trustee will collect the payout, pay for funeral expenses, and distribute the funds to the beneficiaries of the trust according to the terms of the account.

For most trusts, the grantor of the trust can also be the trustee to the trust. However, in order to receive the tax benefits of this trust, the grantor cannot be the trustee of the trust. Thus, most people either choose their spouse, oldest child, or a corporate entity as their life insurance trustee. In many cases, people choose the corporate entity—such as a bank or trust company—because these entities have experience with the responsibilities that come with being a trustee.

Can I Name Someone Else as Owner of my Life Insurance Policy Instead of Making a Trust

Many people think that one can name someone else as the owner to their life insurance policy and receive the same benefits of a life insurance trust. There are two main issues with this approach compared to creating a trust.

First, if a spouse or child is the owner of the life insurance policy and they die before you do, the cash or policy termination value will be in their taxable estate. This is counterproductive as you cannot see the insurance policy to fruition. Furthermore, what value the policy does have is taxed under the normal federal or state estate tax. Additionally, if you have someone else take out a life insurance policy for you, you lose control of choosing who is a beneficiary of the policy, the value or the policy, or even the ability to keep the policy going. A life insurance policy is irrevocable. Thus, once you establish the trust, each of the variables described above cannot change at any time.

How Does a Life Insurance Trust Reduce Estate Taxes

A life insurance trust reduces estate taxes by simply transferring ownership of the policy. By taking the policy out of the grantor’s name, the money that the policy pays out is not taxed under the grantor’s estate.

Other Benefits

Aside from tax benefits, there are a few other key benefits that a life insurance trust offers. First, this account protects the money that beneficiaries receive from a life insurance policy from probate. Probate is a lengthy and costly process in which a court verifies someones will. However, by having the life insurance policy in someone else’s name, this asset does not need to go through probate. Secondly, a life insurance trust protects your insurance policy from divorce, creditors, and legal action against you and your beneficiaries.

Final Thoughts

Trust and estate laws are complex. This is so no matter the type of trust you decide to establish. As such, it is extremely important to have legal representation that can help you correctly set up your trust. The Antonoplos & Associates trust and estate lawyers have over 20 years of experience helping clients in DC, Maryland, and Virginia set up trust. With this knowledge and experience, we can help with any legal issues that occur from setting up your trust.

Furthermore, Peter Antonoplos, founder and managing partner of Antonoplos & Associates has an LLM in Taxation from Georgetown University Law Center. With this knowledge, Peter can help you effectively set up your trust to maximize the tax savings you receive from setting up this account in DC, Maryland, and Virginia.

Contact our DC Law Office for More Information

Finally, for more information regarding estate planning, contact us at 202-803-5676. You can also directly schedule a consultation with one of our skilled attorneys. Additionally, for general information regarding trust and estate law, check out our blog.