Irrevocable Life Insurance Trusts

In general, proceeds of an insurance policy pass free of probate unless the insured person or his/her estate is the owner or beneficiary.

The value of the life insurance policies owned by any individual are considered part of the estate. When the insured dies, the value of those policies is subject to estate taxes as property owned at death.

When the choice is made to illustrate a life insurance policy in a trust, the trust becomes the owner and beneficiary of the policy. This removes the policy from the estate. When the individual dies, those policies placed in trust are no longer considered part of the estate and are not subject to estate taxes.

To avoid the estate taxes, the trust must be irrevocable. This means the insured does not control the trust – the trustee does.

If an existing policy is transferred to a trust and the insured dies within the next three years, the proceeds of the policy are includable in the insured’s estate under the Three Year Rule. To avoid this possible pitfall, the trustee can purchase a new policy using cash in the trust. If the insured then dies within the next three years, the proceeds can be excluded from his estate.

Frequently, the trust pays the policy premiums for a policy in trust with money received as a gift from the grantor. These gifts may lose the annual gift tax exclusion because they are considered to have "future interest" rather than "present interest." To avoid this possible pitfall, the beneficiaries may receive limited powers (Crummey Trust) to withdraw funds. This would give the gift "present interest" and qualify it for the annual gift exclusion even though it is still used to pay the premium.

See life insurance and estate taxes for more details about when the proceeds of a life insurance policy are includable in the estate.