The Disadvantages of a Revocable Life Insurance Trust

A life insurance policy exists to provide financial support for your family after you die. To prevent life insurance proceeds from passing through probate, you may set up a revocable life insurance trust. While these trusts can keep life insurance proceeds out of probate court, they also come with some disadvantages.

About Revocable Life Insurance Trusts

A trust is a legal arrangement in which you transfer ownership of your property to a separate entity. In the case of a life insurance trust, the property is your life insurance policy. When you establish the trust, you also create accompanying documents that determine how the trust will use and distribute the funds from the life insurance policy after your death. If the trust is revocable, you can change these terms at any time.

Taxes

A revocable life insurance trust offers more flexibility, but it won't save you any taxes. All of the proceeds from your life insurance policy will still become part of your taxable estate after you die. If your estate is large enough, your estate may owe federal taxes, state taxes or both. Furthermore, if the trust contains assets other than life insurance, you must pay income taxes on any profits the trust earns.

Creditors

A revocable trust won't protect your life insurance policy or any other assets in the trust from creditors, either before or after your death. While you're alive, any creditors who obtain judgments against you can use them to attach to the trust. After your death, most states allow creditors a certain amount of time to file claims against your estate, which will include the trust and all of the assets it contains. If the estate's other assets aren't sufficient to cover your debts, the trustee will have no choice but to turn over your life insurance proceeds.

Irrevocable Trusts

You can avoid most of the disadvantages of a revocable life insurance trust by making the trust irrevocable instead. However, once you create an irrevocable trust, you can't make any changes to its terms, and you will no longer be able to borrow from the insurance policy. Furthermore, if you transfer a life insurance policy into an irrevocable trust, you must live for at least three years. Otherwise, the irrevocable trust won't protect the policy from creditors or estate taxes.