How to Remove a Life Insurance Policy from an Irrevocable Trust

Situation:  Because the One Big Beautiful Bill Act (OBBA) preserves and modestly increases the estate tax exemption to $15 million, rather than having the planned decrease go into effect, some clients may believe they no longer need to keep life insurance in an irrevocable trust. As a result, I am often asked, “Can a life insurance policy be removed from an irrevocable trust (ILIT) when the trust terms no longer meet the needs of the grantor or beneficiaries?” This Counselor’s Corner addresses this question.

Solution:  Yes; however, several legal and tax considerations must be addressed. It is important to recognize that an irrevocable trust is not necessarily unchangeable or inflexible. An ILIT may include provisions designed to address changes in the circumstances of the grantor and beneficiaries. However, such provisions are frequently omitted. Accordingly, the question becomes: what options are available to remove a policy from an irrevocable trust, or to modify the trust terms, when the trust no longer meets the client’s needs?

Identify Options Available Under Trust Document & State Law. The first place to start is to have the client’s legal advisor review the trust document and the laws of the state to determine under what circumstances:

• The trust can be modified, or
• The trust assets can be distributed to the beneficiaries, or
• The trust assets can be transferred to, or merged into, a newly created trust.

The trust document might contain trust protector language permitting modification or give a trustee the power to distribute to a beneficiary. A court may interpret this as giving the trustee the power to do something to a lesser extent, such as transfer to a further trust.

The laws of many states permit modification of trust provisions. For example, modifications are permitted in states that have adopted the Uniform Trust Code (UTC). In addition, several states have decanting statues that generally allow a trustee with discretionary distribution authority to pour over the assets of one trust to a new trust with modified terms and conditions.

Even where the trust provision or state law permits the distribution of the policy or modification of the trust, this capability may not meet the needs of the client. In those situations, the following options are worth considering.

Review Product Options. The financial professional should determine if there are any available product solutions. One simple product option is to stop premium payment to the problem trust, take a reduced paid-up policy, and establish a new insurance trust that would purchase a new insurance policy. However, this may not be a feasible solution due to policy acquisition costs or in a situation where the insured’s health has changed.

Consider Trustee’s Fiduciary Obligations. Another option is to have the trustee transfer the policy to an individual or another trust that contains more appropriate provisions. In this regard, it’s not unusual for financial advisors to be told, or believe, that a trustee can simply change the ownership and/or beneficiary designation of a policy by completing a carrier’s change of owner/ beneficiary form. While a trustee can change the ownership and beneficiary by executing a carrier’s change form, this can result in liability as a breach of their fiduciary obligation to the trust beneficiaries. Therefore, before executing a carrier’s change of ownership/beneficiary form the trustee’s fiduciary responsibilities must be considered. At a minimum, this means that the trustee will need to structure the transfer as a sale – the trustee cannot simply gift the policy.