Maintaining life insurance can be a great estate-planning tool because it provides almost immediate cash to your estate or loved ones when you die. Unfortunately, if you own the policy and if its death benefits push your estate over $1 million in value as of 2013, the Internal Revenue Service is going to take a sizable piece of the proceeds. You can avoid estate taxation by created a living trust to hold the policy. A life insurance trust must be irrevocable to avoid estate taxes, so you typically can't act as trustee.
Give Up Control
The first rule in funding a living trust with your life insurance policy is that you must give up control of it. You must relinquish the right to change beneficiaries, cash it in, or take loans against it. As far as the IRS is concerned, these are "incidents of ownership" and if you have incidents of ownership, the policy is considered your personal asset for tax purposes. After you set up your trust, you can transfer ownership of your existing policy into the name of the trust – but change the beneficiary to the name of the trust as well. When you draft your trust documents, or when you have an attorney do so for you, you can specify exactly how you want the death benefits used or to whom the trust should distribute them to when you die.
The IRS has certain rules in place to prevent you from emptying your estate of everything in value just before your death so that you can avoid estate taxes. One of these is the three-year look-back rule. After you fund your trust with your life insurance policy, you must outlive the transfer by at least three years or the IRS will pull the death benefits back into your estate for tax purposes.
If timing is an issue and you're concerned about the look-back period, you can simply have your named trustee purchase a life insurance policy after you establish the trust. When you create your trust, you can include instructions for the trustee to buy the policy and name the trust as beneficiary, and you can still dictate what happens to the death benefits when you die. The three-year rule does not apply if the trust purchases the policy and this eliminates any question of incidents of ownership as well.
Whether you transfer your existing policy or direct the trustee to purchase a new one, someone must pay the premiums and it's best if that person isn't you. The easiest way to get around this problem is to simply make monthly cash payments to your trust in the amount of the premiums. The trustee can then use the money to maintain the policy and keep it in place. The IRS has a rule for this as well, however. Because your life insurance trust is irrevocable, it's a separate legal entity from you and any money you give it is a gift, subject to gift tax. As of 2013, however, you can give $14,000 each year to any person or entity before you incur this tax. If your premiums are less than $14,000 a year, the gift tax would not apply.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.