How do life insurance and trust planning work together in Arizona?

Most people buy a life insurance policy, name their spouse as beneficiary, and assume they're done. For many families, this setup works. For families near the federal estate tax exemption, it can quietly create a tax problem that costs hundreds of thousands at death.

The problem with life insurance you own yourself

The IRS counts life insurance death benefits as part of your taxable estate if you owned the policy when you died. Assets over the federal exemption are taxed at 40%. A $2 million term policy that was supposed to protect your family might cost your family $800,000.

And that's only the tax issue. A death benefit paid straight to a beneficiary lands in their bank account with zero strings attached. No protection from creditors, divorce, or a son-in-law's questionable business ventures.

What Arizona law already gives you

Under A.R.S. § 20-1131, life insurance proceeds paid to a named beneficiary (other than your estate) are generally exempt from your personal creditors. If you've named a spouse, child, or dependent family member for at least two continuous years, even the cash surrender value is protected.

That's a real benefit, but only half the solution. The statute protects the proceeds from your creditors. It doesn't protect the money from your beneficiary's creditors once they receive it.

The gold standard: an ILIT that owns the policy

An Irrevocable Life Insurance Trust (ILIT) is a trust created specifically to own a life insurance policy. You don't own the policy; the trust does. You make gifts to the trust, and the trustee uses those funds to pay the premiums.

Because the trust owns the policy, the death benefit is not included in your gross estate for federal estate tax purposes. The trust terms control how and when the money gets distributed, including spendthrift provisions that protect beneficiaries from their own creditors.

The catch: the three-year rule

If you transfer an existing life insurance policy into an ILIT and die within three years of the transfer, the IRS pulls the death benefit back into your taxable estate (IRC § 2035).

The fix is simple but requires planning ahead. Rather than move a policy into an ILIT, have the trust purchase a new policy from the start. If the ILIT owns the policy from day one, the three-year rule never applies.

How premium payments work

With a trust-owned policy, you first make a gift to the trust, then the trustee pays the premium. Gifts to the trust over $19,000 per beneficiary per year can trigger gift tax unless properly planned.

When drafted with "Crummey" withdrawal rights, the trust lets you gift up to $19,000 per beneficiary and still qualify for the annual gift tax exclusion. Crummey rights give each beneficiary a short window to withdraw their share of the gift. The option is almost never exercised, but providing it is necessary to maintain the tax benefits.

Putting it all together

The gold standard isn't an ILIT sitting by itself. Your revocable living trust handles division and control of your assets during life and at death. Your ILIT handles life insurance policies. Your powers of attorney and healthcare directives handle incapacity. Each piece does one job well.