We recently met with a client who was interested in setting up an estate plan using a trust funded by life insurance. But there was a catch: He didn’t want to set up the trust as irrevocable in case he changed his mind. Instead, he was interested in a revocable life insurance trust to avoid giving up control of the funds he put in.
The problem with revocable trusts is that they eliminate a lot of the benefits of using trusts for estate planning in the first place. There are situations in which revocable trusts are appropriate, but they generally should not be used for life insurance purposes.
What Is A Revocable Trust?
A revocable trust is a trust that the owner or grantor can change as needed. They maintain complete control of the trust during their lifetime and can take income from it if desired. For this reason, they are often called “living trusts.”
The main purpose of a revocable trust is to bypass probate and take full advantage of the allowable marital transfer of assets. Without a trust, your assets will instead have to go through a lengthy, expensive process in which they are assigned based on the terms of your will. If your heirs have to pay estate tax, this can create additional complications. With a revocable trust, the items within it bypass probate and go directly to your heirs because the trust is considered a contract. Contracts, such as life insurance policies and annuities, don’t generally go through probate since the beneficiaries are assigned in advance.
A revocable trust does the same thing as a life insurance policy held outside of a trust. A life insurance policy is also considered a contract, so its terms bypass probate and go right to the assigned beneficiary. There may be some instances in which you would want to hold a life insurance policy in a revocable trust.
For instance, if your heir is a minor or has a history of money problems, you can use the trust as a means to control spending. However, using a trust to hold life insurance policies for a responsible adult isn’t really necessary since the life insurance policies and revocable trusts do the same thing—they bypass probate.
While they have their benefits, there are two important things a revocable trust can’t do. First, they don’t protect your heirs from estate taxes. Second, they don’t protect you or your heirs from judgments or creditors. A revocable trust is a trust that’s in your name. Because it’s in your name, it’s considered your asset. To prevent the trust from being considered an asset, you must give up control of it.
Why Life Insurance Trusts Should Be Irrevocable
To protect your assets from creditors and estate taxes, those assets must be held outside of your name. The IRS rules for whether or not a trust is considered part of your estate are covered under its “incidents of ownership” provision.
Incidents of ownership include any benefit or control you have over the trust. The right to designate beneficiaries, use the cash value, receive any ongoing payment, or act as a trustee or co-trustee are all considered incidents of ownership. It’s also recommended that spouses not be added as trustees, but they can be co-trustees.
On top of that, you will be considered to have incidents of ownership if you transfer property or policies to the trust within three years prior to your death. If you are found to have any incidents of ownership, then the value of that policy will be added to your estate and render the trust ineffective.
Creditors can use “incidents of ownership” as a means to prove you own assets in a trust. Once they establish ownership, they can go after the assets in that trust as a means of settling debts or judgments.
The key to avoiding these incidents of ownership is to make the trust irrevocable. Once you give up control of the funds, they won’t be considered part of your estate, so they can’t be used as a means to settle debts or to calculate estate tax. If you are mainly considering using a trust to plan for estate taxes and protect funds from creditors, then you are going to have to use an irrevocable trust.
A revocable trust is really only appropriate if you need to control the spending of a beneficiary or if you want certain assets to bypass probate. It’s not a tool that’s designed primarily for reducing estate taxes. It also is not entirely necessary if you’re using life insurance policies or annuities and trust the beneficiaries to receive the funds from those policies in a lump sum amount. For those cases, it’s simpler to just purchase those contracts outright because these policies will provide the same probate bypass as a revocable trust.
If you’re considering life insurance as part of an estate planning strategy, you may want to consider using a trust as a place to hold these policies. Contact a Howard Kaye representative at 800-DIE-RICH to discuss your options.
