Using life insurance to fund a trust is a highly effective estate planning strategy that allows you to provide financial stability for loved ones while maintaining oversight and protecting assets. In California, where property values are high and estate taxes can significantly impact generational wealth, this technique can play an important role in your broader estate plan. When structured appropriately, funding a trust with life insurance offers liquidity for covering taxes and final expenses, safeguards against mismanagement, and keeps distribution aligned with your long-term goals. To help keep you informed, the Los Angeles attorneys at Schomer Law Group, APC explain what you should know about funding a trust with life insurance.
Why Might You Want a Trust to Hold a Life Insurance Policy?
When a life insurance policy is owned directly by an individual, the death benefit becomes part of that individual’s estate upon death. This not only increases the total value of the estate for tax purposes but also may subject the proceeds to delays during the probate process. In California, where probate can be lengthy and expensive, this delay can complicate matters for surviving family members who need immediate access to funds. To avoid this, many choose to place their life insurance policy inside an Irrevocable Life Insurance Trust (ILIT). Doing so separates the policy from the individual’s estate, which can help avoid federal estate taxation on the death benefit and bypass the probate process entirely. In this arrangement, the ILIT owns the policy and is also the designated beneficiary of the policy, meaning that when the insured passes away, the death benefit is paid into the trust, and the Trustee follows the trust terms regarding the distribution of the trust assets.
Key Benefits of an ILIT
Establishing an ILIT allows for control over how the life insurance proceeds are managed and distributed. Unlike naming a person as a direct beneficiary, causing the full amount of the proceeds to be received in a lump sum, the trust may direct the Trustee to distribute the money over time or under specific conditions. For example, the trust might require that funds only be used for a beneficiary’s education, healthcare, or to purchase a first home. This type of structure is especially advantageous when beneficiaries are underage, have special needs, or struggle with personal financial responsibility. A carefully drafted ILIT can help preserve assets for long-term use while shielding the death benefit from creditors and potential lawsuits. Probate avoidance is another critical benefit. Life insurance proceeds held by an ILIT do not pass through probate, meaning beneficiaries gain access to needed funds more quickly. This can be essential for covering immediate expenses like funeral costs or paying estate taxes, which must often be settled before other assets can be distributed.
Planning and Legal Requirements
To maximize the benefits of an ILIT, the trust should be created before the life insurance policy is purchased because if the insured owns the policy and later transfers it to the trust, the IRS may include the policy’s death benefit in the taxable estate if death occurs within three years of the transfer. This rule is known as the “three-year rule” and can undermine the tax benefits of the trust. Once the ILIT is established, contributions to the trust are used to pay the insurance premiums; however, the IRS considers those contributions as gifts to the trust’s beneficiaries. Consequently, beneficiaries must be given the temporary right to withdraw the contribution for those contributions to qualify for the annual federal gift tax exclusion (currently set at $19,000 per recipient for 20205). This is usually done through “Crummey notices,” which provide each beneficiary with written notice and a short window to withdraw their share of the contribution. While beneficiaries almost never exercise this right, the notice must be properly documented to comply with IRS rules.
The procedural and legal requirements associated with using a life insurance policy to fund a trust can be complex. To ensure that the trust accomplishes your objectives and complies with California and federal law, it is crucial to work with an experienced estate planning attorney when funding a trust with a life insurance policy.
Do You Have Additional Questions about Funding a Trust with Life Insurance?
For more information, please join us for an upcoming FREE seminar. If you have specific questions or concerns about using life insurance to fund a trust, contact the experienced Los Angeles estate planning attorneys at Schomer Law Group APC by calling (310) 337-7696 to schedule an appointment.
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