Life insurance trusts explained
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Trusts can serve as a critical component in estate planning, helping you to protect your assets and protect the financial futures of those most important to you. Used in combination with wills and guardianship documents, they can be essential elements in your estate plan. Trusts come in a number of structures, but they frequently include life insurance. Estate planning can be a complex topic, and you'll need the help of an experienced legal professional to set up a trust. This article is not comprehensive in scope and doesn't provide advice on what you should do in your situation. Instead, it's meant to be a simplified introduction to the subject that helps explain two things:
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What is a life insurance trust, and how is it used?
A trust is a legal vehicle that allows a third party (called a trustee) to hold and manage assets in a way that serves the interests of one or more beneficiaries. A life insurance trust is created when an individual transfers the ownership of their term or whole life insurance policy to a trust. The trust owns the insurance policy, and the Trustee manages its benefits. When the insured person dies, the death benefit is paid to the trust, and the Trustee distributes those funds according to the terms of the trust document. A unique feature of trusts that many find appealing is that they allow the Grantor (the person who sets up the trust) to structure the distribution of assets to beneficiaries in the manner and time they choose. So, for example, the trust can dictate the release of funds to different beneficiaries as certain milestones are reached, for example, as each grandchild turns 18, goes to college, gets married, and so on.
Although life insurance trusts can technically be created with term or permanent life policies, permanent life insurance policies — such as whole life with a guaranteed death benefit — from a reputable life insurance company are commonly used. Forming trusts with term insurance policies can be problematic if the term ends before the insured person dies. The trust could be left unfunded, with nothing to distribute to beneficiaries — leaving them financially vulnerable. Using a permanent universal policy can also be problematic because the death benefit amount typically isn't guaranteed. Under certain circumstances, it can fluctuate, leaving the trust underfunded.
Trusts — whether funded with life insurance or not—- are often viewed as financial tools used by the wealthy for estate tax purposes. However, they can be valuable even if you aren’t rich, especially if you have young children or children with special needs and want to control access to your assets if you die unexpectedly. Working with an experienced financial professional or estate planning attorney can help in understanding policy options and ensuring the trust is set up correctly.
The two basic types of life insurance trusts and how they can be used
Generally speaking, trusts that are created for estate planning purposes are either irrevocable or revocable In either case, the trust owns the assets that it holds, the trustee manages those assets while the insured is alive, then oversees the distribution of trust assets (such as the death benefit) to trust beneficiaries following the insured’s death. While both types of trusts share similar ownership and general management conditions , they have distinct characteristics – the most significant being the degree of control and flexibility allowed.
Irrevocable Trusts
As its name implies, once an irrevocable trust is established, it can't be modified or canceled. So, for example, As the grantor, you will no longer have access to a whole life policy's cash value, which might otherwise be used to help fund retirement or other expenses.1 While irrevocable trusts limit control over your assets, that can actually be beneficial for those with substantial wealth because it may allow them to remove tax liabilities from their estate. That's why very high-net-worth individuals commonly pursue Irrevocable Life Insurance Trusts (ILTS) for estate planning. According to Investopedia, this legal entity can be used help preserve family wealth by providing seven specific kinds of financial and legal advantages:
Mitigating Estate Taxes - The trust owns the insurance policy, so it can be excluded from your taxable estate and therefore not subject to federal estate taxes.
Eliminating Gift Taxes - It allows the trust transfer to be treated as a present gift that may not be taxed, as opposed to a future gift that is.
Preserving Government Benefits - It helps preserve eligibilities for any beneficiaries that may receive asset-dependent benefits from the state or federal government.
Protecting Assets - It can limit the amount of funds that creditors may pursue.2
Controlling Distributions - As noted, the trusts control when and how beneficiaries are paid.
Planning for Generational Legacies - A trust can provide for future generations that haven't yet been born and help them inherit tax-efficient wealth
Shielding from Tax Penalties - The policy’s cash value and death benefits may not be taxed.
In some cases, an ILIT may also be an effective estate planning tool for people with young children, because life insurance benefits cannot typically directly be paid to minors. With an ILIT, if you die, the trust manages and controls funds from the death benefit until your children reach adulthood. However, if you don’t have a need to take assets out of your estate, a revocable trust may be a better choice because it gives you more control over your assets.
Revocable Trusts
These legal entities give you more control over your assets. You can change, amend, or even terminate a revocable trust at any time and for any reason. This can give you flexibility regarding the division of your assets since you can change things as your situation evolves. Revocable trusts are typically used to control the flow of assets to minor children, young adults, or children with special needs. For example, if you have reservations about leaving a large sum of money to an 18-year-old child, a trust can help calm your fears by paying out the inheritance in installments over an extended period of time. This may help ensure that they won't spend their entire inheritance all at once. Though life insurance isn't essential for trust formation, it can be useful to fund these trusts because the benefits are paid almost immediately. This prevents the delays and uncertainty with estate administration because trusts are not probated and allows the liquidation of other estate assets (such as a house or stocks) to occur when the timing is more favorable. A revocable life insurance trust (RUT) can be particularly beneficial for those seeking more control over their life insurance policies as it allows the grantor to change the trust at any time, providing more control over the life insurance policies within their estate planning strategy.
This type of trust may also be a good strategy to consider if you have a special needs child who will require care long after you're gone. A revocable special needs trust holds funds for your child and defines when and how that should be spent. Life insurance proceeds aren't taxed as they go into the trust, and the Trustee manages those funds (along with any other assets in the trust) and pays money out according to your wishes. Because the trust actually owns those assets, it can help preserve your child's eligibility for essential government benefits, like Medicaid, which can be restrictive and means-tested.
Funding a Life Insurance Trust
Funding a life insurance trust involves a few critical steps, starting with transferring the ownership of a life insurance policy to the trust. This can be achieved by either purchasing a new policy and naming the trust as the owner and beneficiary or by transferring an existing policy to the trust. The trust can also be funded with various assets, including cash, stocks, bonds, and other investments.
When considering which type of life insurance policy to use, permanent life insurance policies, such as whole life or universal life, are often preferred. These policies provide a guaranteed death benefit and can accumulate cash value over time, making them a reliable choice for funding a trust.3,4 On the other hand, term life insurance policies may not be as suitable because they expire after a certain period, potentially leaving the trust unfunded if the term ends before the insured person passes away.
Tax Implications of Life Insurance Trusts
Life insurance trusts can have significant tax implications, both during the grantor’s lifetime and after their death. During the grantor’s lifetime, the trust may be subject to income tax on the earnings of the life insurance policy. Additionally, if the grantor transfers assets to the trust, those transfers may be subject to gift tax.
After the grantor’s death, the death benefit of the life insurance policy may be subject to estate tax. However, if the trust is properly structured, the death benefit can be excluded from the grantor’s estate for estate tax purposes. This exclusion can help mitigate estate tax liabilities, ensuring that the trust assets pass to the beneficiaries with reduced tax burdens.
Given the complexity of tax laws and regulations surrounding life insurance trusts, it’s essential to work with an estate planning attorney. They can help you understand the tax implications and ensure that the trust is structured in a way that helps mitigate tax liabilities. An experienced attorney can navigate the intricate tax landscape, ensuring compliance with all applicable laws and helping you achieve your estate planning goals.