What is an Insurance Trust?

An insurance trust is an irrevocable trust set up with a life insurance policy as the asset, allowing the grantor of the policy to exempt asset away from his or her taxable estate. 

Once the life insurance policy is placed in the trust, the insured person no longer owns the policy, which will be managed by the trustee on behalf of the policy beneficiaries when the insured person dies.

How an Insurance Trust Works

The life insurance trust, or irrevocable life insurance trust (ILIT), is often used to set aside cash proceeds that can be used to pay estate taxes, as the life insurance policy should be exempt from the taxable estate of the decedent. 

Key Takeaways

  • An insurance trust can offer some control over how your assets from insurance policies are used after your death.
  • An insurance trust can be used as part of a larger estate plan for your family.
  • For wealthy individuals, an insurance trust can protect against beneficiaries having to pay estate tax.

One catch of an insurance trust is that the life insurance policy must be transferred to the trust at least three years before the death of the insured. To get around this rule, a new policy can be taken out with a spouse as an owner, then placed in the trust.

As an irrevocable trust, changes can only be made by beneficiaries; the owner gives up all control to the trustee.

In the United States, proper ownership of life insurance is important if the insurance proceeds are to escape federal estate taxation. If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.) To avoid estate taxation, some insureds name a child, spouse or another beneficiary as the owner of the policy.

Special Considerations

There are drawbacks to this sort of arrangement, as mentioned above. For instance, doing so may be inconsistent with the wishes of the insured or the best interests of the beneficiary, who might be a minor or lacking in financial sophistication and unable to invest the proceeds wisely. 

The insurance proceeds will be included in the beneficiary's taxable estate at his or her subsequent death. If the proceeds are used to pay the insured's estate taxes, it would at first appear that the proceeds could not be on hand to be taxed at the beneficiary's subsequent death. However, using insurance proceeds to pay the insured's estate taxes effectively increases the beneficiary's estate since the beneficiary will not have to sell inherited assets to pay such taxes. If the size of the taxable estate is below the maximum exclusion figure, it is generally not necessary to set up an insurance trust; in this case, the life insurance will be included in the decedent's taxable estate.