Disadvantages of Putting Life Insurance in a Trust Explained

Life insurance trusts are often used to manage payouts and reduce estate taxes, but they come with drawbacks that can complicate financial planning. While placing a policy in a trust may offer benefits like asset protection or tax advantages, it also introduces restrictions and responsibilities that policyholders should carefully evaluate.

Reduced Control Over Policy

Once a life insurance policy is placed in a trust, the original policyholder no longer has direct authority over it. The trust becomes the legal owner, meaning any changes—such as adjusting beneficiaries, modifying coverage amounts, or canceling the policy—must align with the trust’s terms and the trustee’s discretion. This can be restrictive if financial circumstances change and the policyholder wants to access the policy’s cash value or alter its structure.

Irrevocable life insurance trusts (ILITs) further limit flexibility, as they cannot be modified or revoked once established. If a policyholder later decides they no longer need the coverage or want to change the trust’s terms, they may have no legal means to do so. This rigidity can be problematic if new financial obligations arise, such as unexpected medical expenses or a shift in estate planning goals.

The trustee’s authority depends on the trust’s instructions. If the trust document is too rigid, the trustee may be unable to make necessary adjustments, even if doing so would benefit the beneficiaries. This lack of adaptability can create financial complications if the policyholder’s needs evolve over time.

Complex Administrative Obligations

Managing a life insurance policy within a trust introduces ongoing administrative responsibilities that can be time-consuming and costly. The trustee must ensure the policy remains in good standing by monitoring premium payments, maintaining compliance with legal requirements, and keeping financial records. If these obligations are not met, the policy could lapse or trigger tax consequences, undermining the trust’s intended benefits.

Trusts are subject to federal income tax rates that escalate quickly, reaching the highest tax bracket of 37% at just $15,200 of taxable income in 2024. In contrast, individual taxpayers do not reach this rate until much higher income levels. Any earnings retained within the trust could face significant tax burdens, requiring careful financial management.

Record-keeping is another responsibility, as trustees must document all transactions, including premium payments and disbursements to beneficiaries. If the trust includes Crummey provisions—allowing beneficiaries to temporarily withdraw contributions to qualify for the annual gift tax exclusion—trustees must issue formal notices each time a contribution is made. This can be cumbersome, especially for trusts with multiple contributors or numerous beneficiaries.

Implications for Estate Planning

Placing life insurance in a trust can affect how assets are distributed after death. One major consideration is liquidity, as life insurance proceeds are often used to cover estate settlement costs, such as probate fees or outstanding debts. When a policy is held within a trust, the funds may not be immediately accessible to the estate, potentially forcing heirs to sell other assets, such as real estate or investments, at inopportune times.

If a trust is not structured properly, it can create unintended consequences for beneficiaries. Poorly defined distribution provisions may delay or restrict payouts, limiting access to funds when they are needed most. A trust that only allows distributions at certain ages or milestones might prevent a beneficiary from accessing money during financial hardship. On the other hand, if the trustee has broad discretion, beneficiaries may have to rely on their judgment, which could lead to disputes or inconsistent distributions.

Tax Considerations for Beneficiaries

Life insurance proceeds are generally not subject to federal income tax, but when held in a trust, tax implications can arise. If the trust retains the payout instead of distributing it immediately, any interest or investment earnings generated within the trust may be taxed at the compressed trust tax brackets. Given that trusts reach the highest federal tax rate of 37% at just $15,200 of taxable income in 2024, delaying distributions can significantly reduce the inheritance’s value.

Generation-skipping transfer (GST) tax is another factor if the trust is designed to benefit grandchildren or more distant descendants. The federal GST tax rate is 40%, and while there is a lifetime exemption of $13.61 million per individual in 2024, improper structuring could trigger unintended tax liabilities. If the trust does not qualify as a “skip person” exempt trust under IRS rules, distributions to younger generations could be subject to this additional tax, reducing the intended financial benefits.

Funding and Premium Requirements

Ensuring a life insurance trust remains properly funded requires careful planning. The trust itself must have sufficient assets to cover ongoing premium payments, as the policyholder cannot make direct payments once the policy is in the trust.

If the trust is funded through annual gifts, the grantor must navigate gift tax rules. The IRS allows individuals to gift up to $18,000 per recipient in 2024 without incurring gift tax, but contributions exceeding this amount may require the use of the lifetime exemption or result in tax obligations. Many trusts use Crummey powers, which grant beneficiaries temporary withdrawal rights to qualify contributions for the annual exclusion. However, this requires formal notification to beneficiaries each time a contribution is made, adding an administrative burden.

If the trust lacks sufficient liquidity to cover premiums, the trustee may need to explore alternative funding strategies, such as borrowing against the policy’s cash value or using other trust assets. If premiums are not paid on time, the policy could lapse, rendering the trust ineffective and potentially leaving beneficiaries without the intended financial protection. Establishing a reliable funding mechanism is essential to ensure long-term sustainability.