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When you buy life insurance, you’re providing financial security to your beneficiaries when you die. But you could also leave your loved ones with something else — a whopping tax bill.

Death benefits from life insurance policies aren’t subject to income tax. But the benefits could be counted as part of your taxable estate. If life insurance proceeds push your estate value above the exemption level, the government will hand your beneficiaries a big tax bill. Financial experts say that’s why precise planning is needed — to ensure your heirs get the largest inheritance possible.

An irrevocable life insurance trust is a tool that can help beneficiaries erase the tax burden. The trust “owns” your life insurance policy, pays the premiums, and gives the death benefit to your beneficiaries when you die. By placing ownership of the policy with a trust — not the insured — it removes the death benefit from your estate. If this drops your estate value below the exemption level (see chart), you’ve freed your beneficiaries from a big tax bill. The federal tax reform doubled the federal estate tax exemption. It was $5.49 million in 2017. 

Insurance trusts sacrifice flexibility. Once you put your policy in the trust, it closes the door on many options you currently have.

Federal Estate Tax Exemption Level

2018 40%

$11.18 million (base)

Irrevocable trusts and estate taxes

The cost to set up irrevocable trusts through a major law firm runs between $2,000 and $5,000, primarily because the permanency of such a trust and the amount of upfront work and thought that must go into getting it right the first time.  

It’s relatively easy to make a change in a revocable trust. But it’s much more complicated with an irrevocable trust.

When you place your life insurance policy in the trust, you must designate a trustee to manage it. The trustee can be a relative, but because of the legal requirements and possibly sensitive communications for which the trustee is responsible, many estate owners prefer to hire a trust management company, bank, lawyer or even an insurance company.

Many people who set up irrevocable life insurance trusts intend their beneficiaries to use death benefits to pay the taxes on a large estate. Set up properly, the trust can cover the tax bills of an estate.

Who should use a life insurance trust?

money locked in a trustIrrevocable life insurance trusts are generally for the wealthy. If your estate is valued at less than the exemption level in place at the time of death, your beneficiaries can already receive your death benefit free of estate taxes.

Estate taxes go up as the value of the estate increases, so there is a greater incentive for tax relief if your estate is worth more. On the other hand, many people don’t like the inflexibility or hassle of having their life insurance policies in a trust, and they don’t want to pay someone to manage it.

“Crummey” tax loophole explained

Life insurance trusts can help you when you are alive, too. To make premium payments, you must make cash payments or “gifts” to the trust. You can avoid paying gift taxes on amounts up to $15,000 if your policy is in a trust. 

This tax loophole is called “Crummey power,” in honor of a man named Clifford Crummey who created a trust to which he transferred his assets.

His goal was to avoid estate and inheritance taxes when he died. In 1968, the Internal Revenue Service took Crummey to court, claiming he was using an illegal tax loophole. Crummey won and established a precedent, thus making the trust a legally acceptable tool.

Here’s how it works: You write a check not more than $15,000 per beneficiary as a “gift” to the trust and give it to your trustee. Keeping the amount at $15,000 exempts it from the gift tax. The trustee then writes a letter to the beneficiaries – often referred to as a “Crummey letter” — informing them they can withdraw the money from the trust in the next 30 days.

The goal is to not have the beneficiary withdraw the money. To get the gift-tax break, however, the beneficiary must have the legal right to withdraw the money. 

If the beneficiaries don’t withdraw the money, it becomes property of the trust. In most cases, the trustee will send at least some of the money to the life insurance company to pay the life insurance premium. The rest will remain in the trust and go to your beneficiaries when you die.

It’s important to maintain enough money in the trust to cover the life insurance premiums. An estate planner can help you make sure the trust’s beneficiaries know not to act on a Crummey letter and withdraw money during the 30-day window.

Choosing a trustee

The responsibility of informing beneficiaries of their withdrawal rights is just one reason why it might be difficult to get relatives to act as your trustee. Some trusts are created with a provision that the trustee dictates exactly how much each beneficiary gets — a decision many people feel should be made by a rational, objective person. 

If a trustee skirts his responsibilities by consistently forgetting to notify beneficiaries of their withdrawal rights and failing to pay premiums on the policy, you can ask a judge to appoint another trustee. Trustees can also be sued for damages if they consistently fail to perform their duties. Insurance companies are diligent about notifying the trustee when premium payments are due, so the trustee will have little excuse in court. 

If you ever decide to cancel the life insurance policy within a trust, you can do so by ceasing gifts to the trust. That will stop premium payments and the policy will lapse. The insurance company can negotiate with the trustee to offer a “single premium” term life insurance policy in exchange for the cash value that has been built up in a whole life policy.

Potential pitfalls of irrevocable life insurance trusts

Before you draft an irrevocable life insurance trust, examine the potential drawbacks:

  • The trust is irrevocable, meaning it is permanent. Once you decide to put your life insurance into a trust, there’s no turning back the clock. You cannot take the policy out of the trust, although you can lapse or surrender it.
  • You can’t change the beneficiary of the policy. This could be particularly damaging to you if your family relationships change during the life of the policy.
  • The policy’s death benefit is taxable for three years after transfer. If you transfer an existing life insurance policy to a trust but die within the next three years, the death benefit is still subject to estate taxes. To avoid this, you can have the trust purchase the policy from the start, so there is no transfer.
  • You can’t borrow from your policy. If you want to take out a loan against your policy, forget it. You can’t borrow against the cash value in the policy because you’re no longer the policy’s owner. The trustee can take out a loan, but if the loan benefits the insured in some way, the beneficiary could sue the trustee.

Remember, once you have a trust, you’re committed to it. Make certain that the policy you purchase is one you want for the rest of your life.

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Penny Gusner


Penny is an expert on insurance procedures, rates, policies and claims. She has extensive knowledge of all major insurance lines -- auto, homeowners, life and health insurance. She has been answering consumers’ questions as an analyst for more than 15 years and has been featured in numerous major media outlets, including the Washington Post and Kiplinger’s.