What is the best recourse to do, taxwise?
What are the advantages and disadvantages of
putting this life insurance policy to add to
our (wife/husband) current revocable trust?
Will our "trust" be taxed for this policy
when I am gone? Our estate is less than 1
Here's how it works. If you continue to hold the policy yourself until you die, then the insurance proceeds your relative recieves from the life insurance policy will be included in your gross taxable estate when you die. So, if the insurance pays off $500,000, then $500,000 is added to to your gross taxable estate. If that amount plus any other assets that are included in your estate exceed whatever estate tax credit you have, then your estate will pay federal and state estate taxes. (CA currently has an estate tax that works primarly off the federal estate tax, but CA's estate tax credit may be less than the federal credit when you die, depending on when that occurs.) Your relative, however, does not have to pay any income tax on the life insurance benefits received.
If you put the policy into a revocable trust, the result is exactly the same. That's because a revocable trust is a grantor trust under the Internal Revenue Code (IRC). Grantor trusts are largely ignored and instead the assets of the trust are treated as though they were owned directly by the grantor (you). The same result will occur if you put the policy into an irrevocable trust but reserve the right to change the beneficiary of the trust or the policy.
Thus, for estate planning purposes, if your estate might be subject to estate taxes, what you might do is use an irrevocable life insurance trust (ILIT). With the ILIT, the trust owns the policy in an irrevocable trust and you have very little power to make changes to the arrangement once it's set up. But it removes the insurance proceeds from being included in your estate when you die. One of the problems is funding the insurance premiums. Unless the trust has its own source of income to use to pay the premiums, you'll likely have to pay the premiums yourself. The problem is that those payments are gifts to the trust and subject to the gift tax. They won't qualify to be part of the $13,000 annual gift tax exclusion that you have for technical reasons that I won't go into here, so each premium you pay would reduce your federal and state estate and gift tax credits. You'd also have to file a federal gift tax return each year that premiums were paid.
If you transfer a policy you've already owned for awhile to an ILIT, the value of that policy (i.e. cash surrender or loan value) is similarly a gift to the trust and would result in gift tax consequences. With a term insurance policy, that's probably not a big concern.
I suggest you see an estate planning attorney familiar with tax law (or both an estate planning attorney and tax attorney) for assistance in coming up with the best plan to meet what you want to do at the least tax cost given your circumstances. The fees you pay will be well worth it to make sure your objectives are met and may save you (and your estate) considerable tax, too.