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Question:

We have a special needs trust for our daughter to be funded by a life insurance policy on my husband’s life. We’re wondering if we should transfer the policy to the trust in order to avoid taxes. The trust is irrevocable.

Response:

It can be complicated and there’s probably no benefit to doing so unless you have a large estate or live in one of the few remaining states with their own estate taxes. In 2024, the federal estate tax threshold will be $13.1 million, meaning a married couple together can give away up to $26 million estate tax free. This threshold will be cut in half for people dying after 2025, but it still excludes almost all estates from federal estate taxes. Some states have their own estate taxes with lower thresholds. Massachusetts, for instance, recently raised its threshold from $1 million to $2 million, meaning that married couples can take some basic estate planning measures to exclude up to $4 million from estate taxation.

But if your estate will be subject to estate taxes, whether federally or by your state, you may want to consider transferring the life insurance policy to your daughter’s trust. This is because you are correct that life insurance on a decedent’s life is subject to estate taxation. The typical method to avoid the tax is to transfer the policy to an irrevocable life insurance trust, commonly referred to as an ILIT. However, you need to be aware that ILITs can be cumbersome to administer and be even more complicated if they are also special needs trusts.

Here’s a short course on how this works: The life insurance premiums must be paid by the ILIT. Most taxpayers whose estates are large enough to be subject to estate taxes want to avoid the transfer of funds into the trusts to be treated as taxable gifts. In order to have the taxes qualify for the annual $18,000 gift tax exclusion, the trusts give the beneficiaries a limited right to withdraw any funds transferred into the trust. Part of the process requires that the beneficiaries receive notice of any deposits to the trust through what are called Crummey notices, named for the case that established this system.

This is where the problem comes in with special needs trusts. Typically the beneficiaries of special needs trusts should not have any withdrawal rights because if they do, the trust funds may be considered available when the beneficiary applies for public benefits such as Supplemental Security Income, Medicaid or subsidized housing, and usually one of the main purposes of such trusts is to avoid this from happening. There are a few possible solutions. The trust could not have withdrawal rights, meaning that transfers into it will be subject to gift tax reporting. The trust can include other beneficiaries and they can be given withdrawal rights. Or, if your estate is large enough to be subject to estate taxes, especially federal estate taxes, you can determine that the tax savings of using a standard ILIT rather than a special needs trust outweighs the potential loss of public benefits.

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