Insurance crucial in irrevocable trust

By J. Brendan Ryan • October 23, 2009
Estate planners often recommend that clients set up an irrevocable trust and direct the trust to buy life insurance on the life of the client or jointly on the lives of the client and spouse.
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Properly arranged, this technique allows the death benefit to be payable at the death of the insured(s) without having the death benefit included in the estate for estate-tax purposes. After all, the trust, not the insured(s), owned the policy all along.

What type of insurance is best for this technique?

Rarely does an adviser recommend term insurance for this technique. While many younger breadwinners are content to use term insurance to protect the kids while they are growing up, even they know that this type of insurance gets too expensive after the initial period of ten or twenty years. And insurance for estate-tax planning probably will not be called upon in most cases until later ages. Likewise, starting a term policy at later ages, even if one is still insurable, is an expensive proposition.

If we eliminate term, we are left with permanent insurance, that is, whole life or universal life.

I almost always recommend universal life (UL) in this setting because its cost and flexibility are very compelling.

But some of the flexibility of the original UL, still available today, can be a downside, related to both the interest credited to the cash value and the monthly charges deducted from the cash value. Since these amounts can change, the trustee must constantly monitor the policy to be sure that the cash value stays strong enough to support the policy. Otherwise premiums will have to be increased.

But the later generation of UL contains what is known as the "secondary guarantee," which solves that problem. It says that, as long as the planned premium is paid as due and no significant changes are made to the policy, the death benefit is guaranteed to be there. Many obtain such coverage through a tax-free (or 1035) exchange rollover of cash value from an older policy. Those trustees often accomplish with the stroke of a pen an increase in coverage, a guarantee that they will never have to pay another premium, and a worry-free guarantee of the full death benefit.

The trade-off for this rock-solid guarantee is that the new policy's cash value is eventually locked up and thus unavailable for loan or withdrawal.

But the cash value in an irrevocable trust is usually not a feature that trustees rely upon. Rarely does the trustee ever make cash distributions before the grantors die and the death benefit paid out.

In the irrevocable-trust setting, the later generation of UL with its secondary guarantee is often the safest, most cost-effective life-insurance policy available.