UPDATED: Jul 22, 2011

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Written By: Laura BerryReviewed By: Daniel WalkerUPDATED: Jul 22, 2011Fact Checked

One of the primary and simplest questions most people have about their life insurance policies is how much of the money they have paid premiums on will actually end up in the hands of their beneficiaries. The answer to this question depends on many factors, but one thing that can take a huge bite out of life insurance premiums is inheritance tax.

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What is the Inheritance Tax?

Inheritance, or estate, tax is the federal tax imposed on the estate of a deceased person. While the current limits for exemption are fairly high, a large life insurance policy can quickly push the total assets of the estate over the limit and cost the beneficiaries a great deal of money.

Inheritance tax is only assessed on life insurance proceeds that are part of a deceased person’s estate. This situation exists when the owner of the policy and the deceased person are the same individual. If the owner of the policy is a different person from the deceased, the policy proceeds are not part of the estate, and are therefore not subject to federal inheritance taxes.

How to avoid the Estate Tax with a Life Insurance Trust?

There are several ways to achieve this ideal situation. One way is to transfer ownership of insurance policies to a person other than the insured. However, this must be done at least three years prior to the death of the insured, or inheritance tax may apply.

Another way to ensure that beneficiaries are not assessed inheritance tax is to set up a life insurance trust. A trust transfers ownership of the life insurance policy to the trust itself, thereby avoiding inheritance taxes.

A trust exempts the face amount of the policy from your estate, and this can save you considerable amounts in estate taxes. For example, if you have an insurance policy which inflates the value of your estate by one million dollars, and if all of that insurance is subject to tax because it is outside the exemption limit, your heirs might have to pay up to $350,000 in inheritance tax. However, if that life insurance policy resides in an insurance trust, no taxes would be assessed.

It is also important to remember that most states have their own inheritance tax statutes, and these may apply even if no federal tax is due. A trust may help shelter your insurance proceeds from state as well as federal taxes.

A life insurance trust has three entities—a grantor, a trustee, and a beneficiary. The grantor is the person whose life is insured. The trustee is the person managing the life insurance trust and paying the premiums on the policy. The beneficiary is the person to whom the proceeds of the policy will go after the death of the insured.

The grantor, or the insured person, cannot be the same person as the trustee. There are several reasons for this. First, the grantor must not be the owner of the policy if inheritance tax is to be avoided. Second, the trustee will administer the distribution of the proceeds, so the trustee must survive the grantor. Finally, the trustee must be comfortable with the financial and legal aspects of administering a trust. Often, grantors choose a corporate trustee, such as a bank or other professional organization, to administer the trust.

There are several advantages to having an insurance trust as compared to simply assigning your policy to another individual. If the individual to whom you assign the policy dies before you, the proceeds of the policy will be incorporated into that person’s estate, effectively canceling the benefit of the reassignment for tax purposes. Another reason a trust may be preferable is that if you assign a policy to another individual, and that individual makes changes to the policy, you have no control over the new terms. The owner of the policy could borrow against it, change beneficiaries, or make other material changes to the life insurance policy, all without your consent.

On the other hand, a life insurance trust outlines the terms of the policy, the beneficiaries, and other important factors affecting the policy. However, it is important to remember that most life insurance trusts are irrevocable, so once a trust is set up, you cannot make changes or cancel the trust.

One other factor to consider when setting up an insurance trust is gift tax. Under federal law, individuals can “gift” or give without tax consequences up to $11,000 per year. This amount can be paid into the trust for payment of insurance premiums without tax consequences. However, if you pay the premiums outright, taxes may be applicable. It is important to talk to a professional financial advisor to explore all options and tax consequences as even the information above is often subject to change.

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A former insurance producer, Laura understands that education is key when it comes to buying insurance. She has happily dedicated many hours to helping her clients understand how the insurance marketplace works so they can find the best car, home, and life insurance products for their needs.

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Written by Laura Berry
Former Insurance Agent Laura Berry

Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Car Insurance Agent Daniel Walker