Life Insurance Trust Advantages And Drawbacks

A life insurance trust is a very powerful estate planning tool. An irrevocable life insurance trust, when properly drafted, can offer many advantages. There are some drawbacks to be aware of however. So, before you consider this type of trust, take the time to understand the following advantages and drawbacks.

Advantages of a Life Insurance Trust

  • Gifts of life insurance premiums can be placed into the trust to purchase necessary, even large amounts of life insurance, without potentially increasing the client’s exposure to federal estate taxes;
  • Gifts of life insurance premiums up to $13,000 (if married, up to $26,000) qualify for federal gift tax exclusion and avoid any current gift tax that might otherwise be due;
  • Current estate is decreased through gifts of life insurance premiums – which potentially avoids or lowers federal estate taxes
  • Cash value inside the trust may be created by gifts of insurance premiums – which, after a few years, may be utilized to pay the premiums of the permanent life insurance premiums;
  • Proceeds of the life insurance can eventually be used as liquidity to pay for the grantor’s estate tax, final expenses, inheritances and charitable gift funding.
Drawbacks to a Life Insurance Trust

It is Irrevocable -- First, the trust has to be irrevocable – meaning it cannot be changed. The client cannot have any control over the trust in order for the client to pass on trust assets to his or her intended beneficiaries and not have such assets taxed. There is one exception: The client may stop making transfers into the trust (for example, if the trust has already accumulated enough that premiums are already paid, or no further gift transfers are desired).

There are Specific Steps -- Second, specific steps must be followed in order to qualify for the annual federal gift tax exclusion. Generally, trust gifts do not qualify for the exclusion, but if the trust contains language very specific to a “window of opportunity” (like 30 days), during which the intended beneficiary can withdraw his or her pro-rated portion of the gift transfer, then those gift funds will qualify for the exclusion. The window of opportunity, however, expires at the end of the specified period and if not withdrawn by the intended beneficiary, cannot be later withdrawn. The client can transfer more funds into the trust at another date, however, which will then open a new window of opportunity.

Trustee Must Send Notice – Third, the trustee must send beneficiaries a notice to advise them of their right of withdrawal whenever the client transfers gift funds to the trustee in the trust. If the trustee fails to do the notification, the client is liable for federal gift taxes.

Must be Properly Drafted – Fourth, without proper drafting of the language in an irrevocable living life insurance trust, any beneficiary who doesn’t exercise right of withdrawal may be considered by the IRS to have made a gift that’s taxable in the amount to the trust’s other beneficiaries.

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