A life insurance trust is a form of irrevocable trust that invests the proceeds of a life insurance policy into a trust with designated beneficiaries. Most life insurance policies are owned by the insured. The money is paid when the insured dies, but the payment made to the beneficiaries is taxable.

Because a life insurance trust is owned by a trust, which functions as a separate entity from the insured, the beneficiaries do not owe taxes. Life insurance trusts are often used to avoid passing burdensome estate taxes onto the beneficiaries.

Understanding Estate Taxes

The federal government taxes your estate above a certain amount, based on limits set annually and subject to change. When the estimated value of your estate exceeds this amount, the excess amount if subject to the federal estate tax.

This tax is in addition to any income taxes, probate taxes or fees owed at the time of death, and they must be paid in cash within nine months of the death of the estate owner.

If you hold considerable financial assets, your estate may be subject to very high taxes, thus reducing the amount you can pass on to your heirs by a substantial amount.

Life Insurance Trusts: How They Work

An irrevocable life insurance trust has a grantor, the person creating the trust. A trustee is the person chosen to manage the trust. The beneficiaries are those chosen to receive the benefits of the trust.

The trustee purchases life insurance in the trust’s name, with you as the insured. The trust is typically named as owner and beneficiary.  Upon your death, the money from the life insurance company is paid to the trust. The trust then pays any probate costs, legal fees and other fees related to the death and funeral expenses, and then distributes the remainder to the trust’s beneficiaries.

Benefits of Life Insurance Trusts

Life insurance trusts aren’t subject to estate taxes. They also give you greater control of your assets, since you establish the rules and boundaries of the trust fund. A trust cannot be touched by creditors or the courts, so funds inside the trust are relatively secure.

There are a few things to note about life insurance trusts. They’re irrevocable, which means that once you set up the trust, you can’t change it. Be certain of how you wish to create the trust and the ground rules regarding the management and distribution of funds.

Life insurance trusts aren’t for everyone, but they do offer another option to minimize estate taxes.

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