Life Insurance Trust: Revocable
What is a revocable life insurance trust?
A revocable life insurance trust is a trust that is funded, at least in part, by life insurance policies or proceeds. It can be an effective planning tool that provides a source of liquid funds to your estate for the payment of taxes, debts, and expenses. Moreover, it allows you the flexibility to control the trust assets or amend the trust at any time prior to your death. A revocable life insurance trust is not designed to minimize transfer taxes or income taxes. A revocable life insurance trust does not remove the future appreciation of assets in the trust from your gross estate, nor does it remove the life insurance proceeds. To minimize taxes in these ways, you need to create an irrevocable life insurance trust (ILIT). If you're a business owner, a revocable life insurance trust can be a great way to ensure that your heirs will be able to keep the business running after you die because they will have the cash to keep paying the bills.
Example(s): Adam owns a small but busy diner that he runs with his sons, Eli and Jason. The business has grown since Adam first started it, and it continues to expand and become more valuable. Although the business is thriving, it generates very little extra cash because the cash is used to pay the bills and buy the food. Adam wants Eli and Jason to continue running the diner after he dies. He is worried that when he dies, there will not be enough cash to pay his debts, taxes, and other costs, and that the boys will have to sell the diner. Also, Adam wants to transfer ownership of the diner to Eli and Jason now, but retain control of the diner during his life.
Example(s): He contacts his insurance professional, and together they decide on a life insurance policy that suits Adam's needs. Adam also contacts his attorney, who draws up a document creating a revocable life insurance trust. Adam names himself as trustee, his spouse as cotrustee, and the boys as the beneficiaries. A provision in the trust document permits the cotrustee to pay the costs of settling Adam's estate with the life insurance proceeds. Adam purchases the life insurance policy and funds the trust with it. In addition, Adam transfers the diner's stock to the trust.
Example(s): At Adam's death, the value of the business and the life insurance proceeds are included in Adam's gross estate. The cotrustee collects the life insurance policy proceeds, pays the costs incurred to settle Adam's estate, and distributes the remaining proceeds to Eli and Jason. The two sons continue to pay the bills and operate the diner with little interruption because of Adam's death.
Tip: A revocable life insurance trust is extremely useful if you lack liquidity (e.g., your assets include mainly a closely held business interest and/or real estate holdings).
What types of revocable life insurance trusts are there?
Funded versus unfunded
A revocable life insurance trust can be either "funded" or "unfunded." Technically, an "unfunded" trust is one that either: (1) holds only the life insurance policy and no other assets until your death, or (2) is
named as the beneficiary of the life insurance policy and receives the proceeds upon your death only. After you die, the trust receives the proceeds and administers them according to the terms of the trust. In addition, other assets may be received by the trust along with the insurance proceeds, such as assets poured over from your will or death benefits paid by your employer or employer benefit plan. On the other hand, a "funded" trust holds not only the life insurance policy, but other assets too. You may want to put other assets in the trust in order to coordinate their final disposition with the insurance proceeds. The main reason for a funded trust is that property placed in the trust avoids probate. A revocable life insurance trust is typically unfunded because income that is earned by a funded trust is subject to income tax, even though the income itself is used to pay the premiums. Instead, if the trust holds the policy, you can make regular contributions to the trust to provide the funds needed to pay the premiums. Alternatively, you can simply name the trust as beneficiary and pay the premiums yourself.
Why would you want a revocable life insurance trust?
Provides for your family
The most important benefit of the revocable life insurance trust is that it can help provide for your family. Life insurance can provide cash to help support your spouse and children after you die. This may be especially important if you are young, do not have any other significant assets, or are the primary breadwinner in the family. Life insurance can help bring some peace of mind because it can help improve the financial security of your family even though you're no longer around to provide for them.
Provides cash to your heirs so that your business can continue to operate
If you're a business owner, it is likely that your business may experience a temporary decline after you die. Your heirs may have difficulty with the day-to-day operations if there is not enough cash to keep it going during this period. A revocable life insurance trust can help provide the liquidity needed by your heirs in order to keep the business operating after you die.
Provides funds for the settlement of your estate
A revocable life insurance trust can help provide liquidity to your estate so that there will be funds with which to pay your final income taxes, death taxes, administration expenses, debts, and other costs associated with the settlement of your estate. These costs can sometimes be significant and may take a large bite out of your estate. If there is no cash available, your personal representative may have to sell some of your assets. This may deprive your heirs of property that you intend for them to have. Also, if you're a business owner, this can mean that your heirs may have to sell your business. Life insurance proceeds can be used instead, saving your assets — and your business — for your heirs.
Caution: A provision in the trust document that requires the trustee to make payments to your estate to pay settlement costs may expose the proceeds to your estate's creditors. It is therefore recommended that a provision that allows the trustee to make these payments (in other words, a discretionary power) be included instead.
Provides for professional management of your assets
Although life insurance can be given outright to a member of your family, there are advantages to putting the policy in a trust instead. If the policy is in a trust, the trustee is the legal owner who holds it for the benefit of your heirs. The trustee is responsible for the management and distribution of the trust income and principal. You select the trustee and either determine when the beneficiaries receive the proceeds, or provide the trustee with discretion to decide the amount and timing of distributions. A professional trustee (e.g., a bank) can invest the assets in the trust in a way that earns the most income. This may be especially attractive if your beneficiaries are minors or others who do not have the capacity or judgment to manage the policy or proceeds. This may also be attractive if you are in your golden years and no longer want the bother of managing some of your assets.
Assets in the trust are not subject to probate. This is true for any other type of asset you transfer to the trust. Therefore, trust assets can be made available to your beneficiaries more quickly than if they were to pass through your probate estate. In addition, your estate will avoid probate costs for these assets.
Maintains your privacy
Assets that pass through probate are a matter of public record, open to anyone who cares to look at it. Because the trust assets pass outside of probate, distribution of this property remains private (unless, of course, you choose to tell someone).
Trust assets may be protected from creditor's claims
Assets you put in a revocable life insurance trust may be protected against the claims of your creditors, depending on the laws in your state. However, because you retain control over or rights to the assets in a revocable life insurance trust, they may be vulnerable. Check with your state or your attorney to find out if the assets in a revocable life insurance trust are protected.
Lets you retain control over the trust and trust assets
A revocable life insurance trust gives you some flexibility because you can alter, amend, and even terminate the trust if you choose. This may be attractive if the thought of losing complete control over your assets troubles you.
What are the tradeoffs?
Future appreciation of trust assets is not removed from your estate for estate tax purposes
In order to avoid potential estate tax liability, you can't retain any incidents of ownership. By its very nature, you will retain some incidents of ownership in a revocable life insurance trust. Therefore, the full value of the trust (including any other assets you transfer to the trust) will be includable in your estate for estate tax purposes. Since you may not be able to remove future appreciation of the assets you transfer to the trust from your estate, you should consider creating an irrevocable life insurance trust (ILIT) instead.
Insurance proceeds are not removed from your estate for estate tax purposes
Because you retain incidents of ownership in the insurance policy up until the date of your death, the insurance proceeds will be includable in your estate for estate tax purposes. Only proceeds on policies transferred to a properly structured irrevocable life insurance trust (ILIT) will be removed from your estate.
Distributions may be subject to generation-skipping transfer (GST) tax and/or gift tax
Distributions of property from the trust may be a taxable transfer for GST tax and/or gift tax purposes and may result in tax liability, subject to the application of the annual gift tax exclusion (currently $16,000), the applicable exclusion amount (in 2022, $12,060,000 plus any deceased spousal unused exclusion amount), and the GST tax exemption ($12,060,000 in 2022).
A revocable life insurance trust is ignored for income tax purposes
The IRS does not treat a revocable life insurance trust as a separate legal entity as it does with most forms of trusts. All trust income, deductions, and credits will flow through to you on your personal income tax return. Therefore, you will be taxed on any trust income. This may be negligible if it is an unfunded trust, or it could be significant if you transfer substantial amounts of property to the trust.
May be costly
You will incur more costs if you put life insurance in a trust than if you give life insurance outright. You will have to pay legal fees to draw up the trust document and perhaps accountant's, tax preparer's, and trustee's fees as well.
How do you implement a revocable life insurance trust?
Assuming you have decided that you want to make a transfer of a life insurance policy, and that the transfer should be made in trust rather than outright, there are specific steps you should follow for effective implementation.
Contact your insurance agent
If you are purchasing a new policy, your insurance agent will help you decide what kind of policy is best for you.
Hire an attorney
There are many complex legal issues that can arise when you set up a trust. You should hire an experienced estate planning attorney to draft the trust document and advise you on these complex legal issues.
Choose your beneficiaries
You will have to select the beneficiaries of the trust. Spouses are a common choice, but this may not be the best. Typically, it will be either your children and/or your grandchildren. If your children or grandchildren are minors, then you should also appoint guardians for them.
Select a trustee
The decision of who serves as trustee and successor trustee is an important one. You will probably want to name yourself as trustee. Alternatively, you could choose an independent trustee, such as a bank, sibling, parent, or anyone else who is not a beneficiary. You may want someone who has experience administering a trust and who understands that the purpose of the trust is to hold a life insurance policy on your life.
Transfer/buy the policy and fund the trust, if desired
You may transfer an existing policy to the trust, buy a new policy and transfer it to the trust, or have your trustee purchase the policy. Alternatively, you may simply designate the trust as the beneficiary of the life insurance policy. In addition, you may want to transfer other assets to the trust. Your insurance professional and your attorney should assist you in transferring ownership.
File GST tax and/or gift tax returns, if necessary
If you make distributions from the trust during your life, then you may have to file a GST tax and/or gift tax return. If you have also exhausted the unified credit, then you may have to pay taxes too. If this is the case, you may want to consult with your accountant or tax attorney prior to making the distribution.
Include trust income on your personal annual income tax return
Any income earned by the trust must be included on your personal income tax return for the year in which it is earned.
What are the tax implications of a revocable life insurance trust?
Income tax implications
Because you retain the right to revoke the trust, you are considered to be the owner of the trust. Therefore, any income earned by the trust must be included on your personal income tax return for the year in which it is earned. After your death, the trust becomes a separate taxpayer.
Estate tax implications
The full value of the trust will be includable in your estate for estate tax purposes. To avoid this result, you need to create an irrevocable life insurance trust (ILIT).
Gift tax implications
Under the gift tax laws, a gift is not taxable until it is complete. Because you retain the power to revoke the trust at any time prior to your death, any transfers of property you make to the trust are incomplete and not subject to gift taxes. However, if you make a distribution to a beneficiary during your life, that distribution makes the gift complete and subject to gift taxes (reduced by applicable deductions, the applicable exclusion amount, and the annual gift tax exclusion).
This article was prepared by Broadridge.
LPL Tracking #1-05113492