Life Insurance Trusts

Many individuals who own or are considering the purchase of a life insurance policy, have used an irrevocable life insurance trust to reduce estate taxes while providing for their loved ones. Properly structuring this type of trust requires sophisticated tax and estate planning expertise. This article does not constitute such advice and is intended for educational purposes only. Ask your financial advisor if a life insurance trust might be appropriate for your situation.

Life insurance proceeds are free from income taxes when they are paid to ones survivors. However, the death benefits on policies are included in one's taxable estate. This is often overlooked when people estimate the size of their estate, since life insurance is not always counted as an asset at face value.

The idea of an irrevocable life insurance trust is to remove the policy proceeds from one's taxable estate. An irrevocable life insurance trust avoids estate taxes because it is a separate legal entity in which the individual retains no interest. In order to obtain this benefit, however, one must forfeit all control and ownership rights to the life insurance policies held in such a trust, which is why the trust is "irrevocable."

An individual can accomplish the goal of avoiding estate taxes and still provide one's heirs with the ability to receive income or principal of the trust at the direction of the trustee, or pursuant to guidelines one sets out in the trust. This would permit the proceeds to be used as needed by the heir, but protect the balance from tax.

One may create a life insurance trust by transferring an existing policy to an irrevocable trust. The transfer is considered a taxable gift, but the tax is calculated on a value close to the cash surrender value of the policy, which is usually less than the death benefit. Therefore, the tax cost of transferring a policy during one's lifetime could be substantially less than the estate taxes that otherwise would be due upon the individual's death. Note: If the individual were to die within three years of the transfer, the policy proceeds would be brought back into his/her taxable estate.

Another approach to setting up the trust is to have the trustee apply for a new policy on the individual's life, and to transfer cash to the trust annually so that the trustee may make the premium payments. The cash transfers are generally considered taxable gifts. However, because the individual never had any ownership rights to the policy held in the trust, the policy proceeds (including the income-tax-free buildup in value) would not be included in his/her taxable estate -- even if the individual were to die within three years of the purchase of the policy.

When applying for eligibility for Medicaid, the state agency will "look back" three years to determine whether the applicant had divested of significant assets. Penalties may apply (depending on the state you live in) that may restrict your eligibility for Medicaid. There has been a great deal of controversy over "Medicaid Trust Mills." Make sure your financial or legal advisor is qualified to design your trust. Some advisors have touted "one size fits all" trusts that courts have found to be ineffective.

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