One of the things that people come across when they are researching life insurance is the life insurance trust. Although the life insurance trust is fairly simple it can confuse a lot of people because when a life insurance trust is set up it can have a number of repercussions that differ significantly from a regular life insurance policy.  Here is what you need to know about this special kind of life insurance. In order to fully appreciate the differences between traditional life insurance and a trust however, you first should know how conventional life insurance works, because until you understand the differences between having a life insurance trust set up and just owning a regular life insurance policy you won’t really be able to decide which one better suits your needs.

Traditional Life Insurance

Life insurance in a general sense is a type of insurance designed to cover funeral and living expenses when someone dies. Unlike other types of insurance, the companies that offer it know that you are going to die eventually, since everyone does, but they are betting that you will pay more in premiums over your lifetime than they will have to pay out (they also bank on people surrendering their policies instead of collecting the payout on death). There are several different types of life insurance however, and lots of options exist even within those types. To understand a life insurance trust, you need to know something about the various types of insurance.

There are three major forms that life insurance usually takes: term life insurance, whole life insurance and universal life (including variable univeral life insurance). An explanation of each of these three types is below.

Term Life Insurance

Term life insurance is the most common type of life insurance, because the premiums are affordable for most people and the payouts are attractive. It works very simply: the policy lasts for a predefined “term” or period of time, with twenty years being the most common. If the person covered dies within that term, the life insurance pay the beneficiary. If not, the insurance company gets to keep the premiums paid for the entire twenty years. However, most of the time it is easy to review and convert term life insurance into a whole life policy which will be permanent.

Whole Life Insurance

Whole life insurance is different from term life insurance primarily in that it doesn’t last for a specific period of time. It is for a person’s entire life, which means that the premiums are high because the insurance company knows that it will have to pay eventually and they are betting on the insured person or persons living long enough to pay more in premiums than the insurance policy pays out. One of the benefits of whole life insurance is that it has a value that builds over time and allows you to eventually borrow from it if you need.  You can also collect dividend payments if you so choose, or use dividend payments to increase your coverage.  Whole life is more expensive but it comes with additional features beyond what term offers.

Universal Life Insurance

Finally, a third type of life insurance is universal life insurance, which is similar to whole life insurance but the value of the policy is determined by financial factors like short-term interest rates.  Universal life is significantly more complex than most other forms of coverage but basically the premium payments are discretionary, as long as there is enough cash in the policy to cover the actual cost of insurance.  Universal life is good for people who want to put a lot of money into a life insurance policy as if they are looking at it as more of an investment.

The Life Insurance Trust (LIT)

A life insurance trust is a trust that can not be revoked.  The purpose of the trust as implied by the name is an account created solely for the purpose of having a life insurance policy and it is used to create an advantageous tax situation that allows the ultimate trust beneficiaries to inherit money in a more tax efficient manner than through either a regular life insurance policy or other means.

life insurance trust lawyerA LIT  is both the owner and beneficiary of a policy. With a conventional insurance plan, if the person who owns the policy is also the person who is insured under it, when he or she dies an estate tax of 35% is assessed by the federal government on any amount above the exemption.  A life insurance trust allows more money to be passed on free of tax.

That’s exactly what the advantage of having a life insurance trust is. If the person who is insured dies, and the policy is in the life insurance trust, those who would inherit the money paid to the beneficiary are not required to pay estate tax on the policy. So with a $20,000,000 policy, whoever inherits the money saves almost $7,000,000 (if the total proceeds would not be exempt).

Estate tax is different than income tax and you may be wondering which policy you have to pay income tax on. The answer is neither. No matter if you have a conventional life insurance policy where you have it in a life insurance trust, you don’t have to pay income taxes on it.

Who it is For

As you may be able to tell, a LIT is for people who are very wealthy.  Currently in 2016, the first $5.45 million dollars can be passed on tax free from an individual.  If your entire estate plus life insurance is worth less than this, you probably have no use for a life insurance trust.

How it is Set Up

You need to set up a life insurance trust through a lawyer.  There are a number of lawyers who will do this rather inexpensively, but chances are if you need one you have enough money to cover the costs.  It is worth it to have a lawyer knowledgeable in estate law do it correctly because it could save your heirs millions.

The Disadvantages of a Life Insurance Trust

However, don’t think that having a life insurance trust is all positive things because there are some disadvantages that come with the trust that may be a problem for some people depending on what you need from your insurance policy. The first thing is that you can’t borrow from a life insurance policy within a trust because if you’re borrowing from it the government considers you the owner and the estate tax kicks in. With some types of conventional insurance, when the value is high enough you can often borrow from your policy. That won’t work with a trust.

In addition, you are not going to be able to change the beneficiary of the policy once it is part of the trust policy. This is something that is easily accomplished with a conventional life insurance policy and for those who aren’t 100% sure who their beneficiary is going to be, this could be a problem. The life insurance policy that you have with the life insurance trust is not revocable. This is going to be permanent and you want to be aware of that before you choose this option.
That means if you get to a point where you can’t get life insurance anymore this will be your only life insurance.

There are a couple other things to be aware of is well. You will need to pay your premiums without using the credits from your estate tax and your gift tax exemptions. If every year you transfer the money to the trust to pay for your premiums you’re going to have to pay taxes on it because it will be considered a taxable gift. In addition, if you are the party that is insured by the policy you are not going to be able to serve as the trustee for the trust. That means that you are going to have to hire someone – or trust a friend or family member to serve as your trustee – if you want to be the person insured.

So do you Need One?

We can’t really tell you from a website.  Chances are that if you are reading this you probably have significant assets.  If you are planning to pass on millions of dollars after you die, you probably should consult a tax attorney who can give you advice on the most efficient way to accomplish that.  The reality is estate tax law is extremely complex and there is no one size fits all solution.

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