Estate planners and insurance professionals often recommend that people create a separate trust to own life insurance policies. Whether a life insurance trust makes sense for you depends on your goals and a number of other factors.

Why own life insurance in a trust?

If you own a life insurance policy, you probably know that the beneficiaries you’ve named to receive the insurance proceeds when you pass away get that money income tax-free.

However, payout on a life insurance policy may not be exempt from estate tax, which is why planners often recommend that a trust own your life insurance policy instead of you owning it.

If you’re married and you name your spouse as the beneficiary of a life insurance policy that you own, there’s no estate tax on the insurance proceeds when you pass away because the payment to your spouse qualifies for the unlimited marital deduction from estate tax.

When your spouse eventually passes away, however, any of the proceeds that are still in your spouse’s name are subject to estate tax. An insurance trust can be an easy way to shelter the insurance proceeds from eventual estate taxes and prevent those proceeds from pushing your  spouse’s estate value over the estate tax exemption threshold. And if you aren’t married, or if you and your spouse have a policy that only pays out on the death of the second spouse to die (a survivorship or second-to-die policy), having a trust as the policy owner can protect the insurance proceeds from estate tax on the death of your survivor. And don’t think only of the federal estate tax; if you live in one of the states that has a separate, state-level estate tax, you may want to consider an insurance trust even if your net worth (plus insurance proceeds) doesn’t exceed the federal threshold.

How it works?

Existing insurance: If you already own one or more life insurance policies, you can change ownership from your name to your insurance trust.

First, you would work with an estate planning attorney to create the trust document. You’ll want to consider who will act as trustee of the trust and under what circumstances your beneficiaries will have access to the insurance proceeds.

Once the insurance trust is drafted and signed by you and the trustee or trustees, you should get a change of ownership form from your insurance broker or from the insurance company. Once you’ve transferred ownership by completing the form and submitting it to your insurance company, the trust owns the policy and payments of the insurance proceeds to the trust should be excluded from your, and your spouse’s, taxable estates. At the same time you change ownership of the policy, you may also want to name the trust as beneficiary.

There are two wrinkles, however:

• In order for the insurance proceeds to be outside of your estate, you need to survive for more than three years from the date you transfer the policy into the trust. If you die within that period, the life insurance amount will be included in your estate for estate tax purposes.
• The transfer of the life insurance policy into trust is a gift and could use up a portion of your gift tax exemptions so you’ll want to work with your attorney and tax advisor.

New insurance: If you don’t own an insurance policy today, the most effective way to proceed is to create an insurance trust first. The trust should then apply for insurance on your life. The trust will be the original owner when the policy is issued, which means that the insurance amount will be outside of your estate from the moment the policy is issued – there’s no three-year lookback.

The mechanics

Once the policy is in your trust, you and your trustees still have to make sure that premiums are paid every year. The trust makes the process a little more complicated, but it will quickly become routine.

• Premium notices will be sent to the owner – in this case the Trustee or Trustees.
  • Make sure the trustees let you know when they receive a premium notice.
• You contribute the amount of the premium to the trust; this is a gift. The trust will need to have a checking account for this purpose; you can write a check or electronically transfer funds to the trust
• When you transfer the funds, you should provide the trustees with a notification that you’ve made a contribution to the trust in the amount of the premium.
  • Your lawyer should provide you with a form of this notification when he or she creates the initial trust for you, but there’s no particular form that’s required
• The trustees then notify the beneficiaries that you’ve made a contribution to the trust and they have a right for a short period of time to withdraw their proportionate share of the amount you contributed
  • This will allow your contribution of the premium amount to the insurance trust to qualify for your annual gift tax exclusion ($18,000 in 2024); any contributions in excess of the annual exclusion may use up a portion of your lifetime gift tax exemption ($13.61 million in 2024)
  • The beneficiaries will have a short period of time to make a withdrawal; in general, they will never exercise that right so that the contribution would remain in the trust to pay the premium
• Once the waiting period expires without the beneficiaries having exercised their withdrawal right, the trustee pays the premium

You and the trustees will follow this process every year. Eventually, when the children reach the age of majority, they will have to be notified of their right to withdraw (but you would make it clear to them that withdrawal of any one year’s gift would not be in their best interest longer term).

If you find this process to be cumbersome, you may want to consider making a large upfront contribution to the trust (that likely would use up a portion of your lifetime gift tax exemption). These funds could be used over the term of the policy to pay premiums annually rather than making annual gifts. You’ll want to coordinate this gift with other large gifts you’d like to make and discuss with your estate attorney to ensure that this makes sense in light of your overall gifting strategy.

After the policy matures

Ultimately, when you pass away, assuming the trust is both owner and beneficiary of the insurance policy, the trustees will collect the insurance proceeds. They will generally provide the insurance company with a death certificate and any forms required by the insurance company; once it receives those forms, the insurance company pays the policy proceeds to the trust.

At that point, your insurance trust becomes a regular trust funded with cash – the trustees can use or invest that cash in line with the terms of the trust, including providing your estate with liquidity by purchasing assets from your estate, and then manage the assets in the trust for the benefit of the beneficiaries.

What kind of insurance is in the trust depends on its purpose

If you want to provide for a surviving spouse as well as descendants, a policy on just your life makes the most sense in an insurance trust. Commonly, level-premium term or some kind of permanent insurance (whole life or universal life) are used in this situation.

If estate tax liquidity is a primary goal, you should consider having some kind of permanent policy, since term rates will likely become very expensive after the level-premium period expires and as you get older. Another type of policy that can work to offset estate expenses is second-to-die or survivorship, which insures two lives (typically the joint lives of a husband and wife).

For more information about different kinds of life insurance, see our WealthFocus article on Life Insurance.

Consult with a J.P. Morgan Advisor and your attorney to understand the alternatives and figure out whether an insurance trust may be the right solution for your situation.