What Is a Life Insurance Trust?

By Amber Gunn, CTFA and Mariam Hall

As the name suggests, a life insurance trust is a trust designed to own life insurance. This type of trust will most often be irrevocable. An irrevocable life insurance trust, or “ILIT” is a trust created to own and control a life insurance policy while the insured is alive, and then to manage and distribute the proceeds paid out after the insured’s passing according to the terms of the trust and the grantor’s intent. If a couple sets up a life insurance trust jointly, the insurance policy purchased inside the trust is often a “survivorship” or “second to die” policy, which pays the death benefit on the passing of the last surviving spouse.

How Are Life Insurance Trusts Used?

Life insurance trusts are used for many reasons, including minimizing estate taxes, avoiding gift taxes, protecting assets, retaining control over the distribution of insurance proceeds, protecting government benefits, and many more estate- and tax-planning considerations. Learn more here about how life insurance trusts are used.

Funded vs Unfunded Life Insurance Trusts

Life insurance trusts can be either “funded,” where the trust owns both a policy and income earning assets that provide for the payment of insurance premiums, or “unfunded,” where the trust owns the policy and the grantor makes an annual contribution to the trust that is used to pay the insurance premiums.

Funded and unfunded life insurance trusts are effective tools. However, keep in mind that with a funded life insurance trust, the transfers to fund the trust may be subject to the gift tax (when transferring income-producing assets to the trust) and income tax for a grantor trust. Unfunded insurance trusts make use of the grantor’s annual gift tax allowance to maximize tax savings and pay the annual insurance premiums.

Insurance Premium Tax

When establishing a life insurance trust, one of the several factors in deciding where the trust will be domiciled is the insurance premium tax rate in the state where the trust will be located. All states charge some form of tax on insurance premiums, including life insurance premiums. While this tax is rarely noticeable on most insurance products, for large life insurance policies with high annual premium amounts, it can make a big difference. This consideration becomes particularly relevant for annual premium amounts in excess of $100,000 a year, which is usually the case with private placement life insurance.

Insurance premium tax rates vary significantly among states. Alaska and Delaware are two states with particularly competitive insurance premium tax rates for large premium amounts. Alaska’s insurance premium tax rate is 2.7% on the first $100,000 of the premium, and then 0.08% on premium amounts in excess of $100,000. Delaware’s insurance premium tax rate is 2.0% on the first $100,000 of the premium, and premium amounts in excess of $100,000 are tax free. In contrast, most other states average between 1.75% to 2.5% on the entire premium amount, for example, California 2.35%, Nevada 3.5%, Florida 1.75%, New Jersey 2.0%, and New York 2.0%.

Important Considerations for Making ILITs Work

There are several important factors to keep in mind when setting up an irrevocable life insurance trust such as how the trust will be structured to avoid unnecessary gift tax, where the trust will have “situs” or be located, and who will be appointed as the trustee to make sure that the plan is carried out as the grantor intended. Read more here to learn about the important considerations for making irrevocable life insurance trusts work.

If you have more questions about life insurance trusts, get in touch with a trust officer at Peak Trust Company today!