Use an Irrevocable Life Insurance Trust to Reduce Estate Tax

A man signing a document, close up of his hand and paperworkThe federal estate tax exemption only affects significant estates. If your property and investments exceed 12.92 million in 2023, find ways to minimize taxes. An irrevocable life insurance trust allows you to pass on money to your heirs while avoiding both the federal estate tax and any applicable state estate tax. 

Changing Tax Laws

Federal and state tax laws change frequently. The current rate will sunset in 2026 and essentially be cut in half to about $6 million per individual. If you haven't discussed how this will affect your estate plan, reach out to an estate planning attorney in your area to understand your best options.

One way to prepare for any estate taxes your estate may owe is by setting up an irrevocable life insurance trust and funding it with a policy that has a death benefit large enough to pay your heirs some or all of the amount your estate will be taxed. If you purchased a life insurance policy directly, it could end up being taxed as part of your estate. But if a trust owned the policy, it could pass outside your estate. While a life insurance trust can be highly beneficial, it is also complicated to set up and maintain properly.

Requirements for Funding an Irrevocable Life Insurance Trust 

  • Trustee. If you are setting up the trust, you aren't allowed to serve as a trustee. If you are the trustee, you have control of the trust, which could lead to the trust being included in your estate. You will need to name another trusted person or financial institution to act as trustee. 
  • Policy ownership. The trust must own the life insurance policy. If you transfer an existing policy to the trust and die within three years, the policy will still be considered a part of your estate. To avoid this risk, the trust can purchase a policy directly rather than receive an existing policy. 
  • Premiums. You need to transfer funds to the trust to pay the policy premiums, which creates an issue with gift taxes. A transfer to a trust is usually not subject to the $17,000 yearly gift tax exclusion. For a gift to qualify for the exclusion, the recipient must have a "present interest" in the money. Because a promise to give someone money later does not count as a present interest, most gifts to trusts aren't excluded from the gift tax. To avoid this, you can use something called a Crummey power, which gives beneficiaries the right to withdraw the funds transferred to the trust for up to 30 days. As part of the process, the trustee needs to send them a letter, known as a Crummey letter, letting them know about the trust funding and their right to withdraw the funds. After the 30 days have passed, the trustee can use the funds to pay the annual insurance premium. You run the risk of the beneficiaries withdrawing the funds, but if they know that by allowing the money to stay in the trust they will receive more money later, it shouldn’t be a problem. 
  • Beneficiaries. The beneficiary of the life insurance policy is usually the trust. Once the funds are deposited in the trust, the trustee can distribute the assets to the beneficiaries in the way specified by the trust. For example, if your beneficiaries are minors, you can wait to have the trustee distribute the assets. Keeping the assets in the trust will also protect them from your beneficiaries’ creditors.   

Get Professional Advice

The downside of an irrevocable life insurance trust is that you do not have the ability to change it once it is set up, although the policy would effectively be canceled if you stopped paying the premiums. If you are considering this type of trust, discuss it with an attorney near you. 

Contact us

Questions? Contact us at Chambliss, Bahner & Stophel, P.C.

Chambliss, Bahner & Stophel, P.C.
Liberty Tower | Suite 1700 | 605 Chestnut Street | Chattanooga , TN 37450
Phone: 423.756.3000