Is life insurance trust a good idea for you? Well, if you are looking to reduce your estate tax liabilities, setting up a life insurance trust may be in your best interest, as well as that of your heirs and beneficiaries. Before going further, you must understand what a life insurance trust is. A life insurance trust is a trust that is set up for the purpose of owning a life insurance policy. If the insured is the owner of the policy, the proceeds of the policy will be subject to estate tax when he dies. But if he transfers ownership to a life insurance trust, the proceeds will be completely free of estate tax.
Don’t be under the impression that all life insurance proceeds are exempt from taxation. Life insurance proceeds are taxable under many circumstances. If your estate is large enough to be subject to estate tax, the proceeds from your life insurance policy will be taxed at the estate tax rate. But if you set up the ownership of the policy properly, estate taxes are not applied to those proceeds. The biggest advantage of a life insurance trust is that it can legally help your heirs to avoid estate tax on the proceeds of your life insurance policy.
Before you consider setting up a life insurance trust, you must consider its drawbacks. There main drawbacks:
1. You cannot change the name of the beneficiary. Once you establish a life insurance trust, you will not be able to make changes to the beneficiary (or beneficiaries) named in the policy or of the trust.
2. You cannot use the policy as a collateral. When you set up a life insurance trust, you give up the ability to borrow money against the policy. You no longer own the policy. The policy belongs to the trust. You can’t use something that you do not own for collateral.
3. Life insurance trusts are irrevocable. You cannot take back ownership of the policy if you change your mind. Setting up a life insurance trust is a permanent decision.
4. You loose control over the policy. In order not to have the benefit included in your taxable estate, you must have no control over the policy.
5. You could be exposed to gift tax liability if the policy given to the trust has value or if gifts of funds to pay premiums are not handled in a way to make them eligible for the $12,000 per year per donee exclusion.
6. There will be costs including legal and accounting fees associated with the setting up and administration of a life insurance trust.
