Life Insurance and Living Trusts

Living trusts are wonderful ways of avoiding probate by pre-assigning and setting aside assets that one wishes to be willed to their heirs. As the name implies, living trusts are set-up and maintained during the grantor’s (the owner of the assets) life. Upon the grantor’ death, this trust becomes irrevocable and must be executed per the grantor’s prescribed wishes.

In hopes to avoid disputes over assets or death claim payouts, many explore the idea of assigning their life insurance ownership or death benefit to their living trust. This assignment would also allow the grantor to dictate when and how those proceeds are to be used. The trouble with this type of planning is that living trust are revocable. The IRS deems that life insurance death benefit is taxable if the proceeds benefit the estate of the insured. If the total assets of the estate are below the State and Federal Estate tax exemption then this is not a concern, but you must know what those exemption limits are before determining this route.

In a living trust, the grantor still maintains control and direction over the assets while alive. This active means of control triggers yet another IRS tax determination called incidents of ownership. If the insured maintains the ability to change policy features, access cash values, or re-assign beneficiaries, they have incidents of ownership. If incidents of ownership are found to have occurred in the life insurance policy, the benefits will again be included in the taxable estate of the insured. The IRS even goes as far as to enforce this rule retroactively. They give a 3 year look back on life insurance policy ownership, and if a transfer or ownership assignment was made in that time, they will still apply that policy to the taxable estate of the insured.