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.

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:

  1. Minimizing 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.
  2. 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.
  3. Preserving Government Benefits - It helps preserve eligibilities for any beneficiaries that may receive asset-dependent benefits from the state or federal government.
  4. Protecting Assets - It can limit the amount of funds that creditors may pursue.
  5. Controlling Distributions - As noted, the trusts control when and how beneficiaries are paid.
  6. Planning for Generational Legacies - A trust can provide for future generations that haven't yet been born and help them inherit tax-efficient wealth
  7. 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. 

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.

A final note: The legal and tax implications of creating a trust are much more involved than those for the creation of a simple will, which many people choose to create using an online legal service. If you believe a special needs or other trust might help your estate planning needs, be sure to consult with a trusted attorney who specializes in trusts, understands estate tax law, and can help determine if it’s the right strategy for your needs.

Frequently asked questions about life insurance trusts

Should my life insurance be in a trust?

Most people do not need to place their life insurance in a trust. This is because life insurance trusts can be expensive to form and can create significant tax and legal ramifications. They can also add unnecessary complexities to estates. However, if you have substantial wealth you want to protect, a life insurance trust could be a valuable tool for estate planning. It can also be useful if you want to leave money to underage or special-needs children. An experienced financial professional or knowledgeable attorney can help you determine if you should pursue this option.

What are the benefits of a life insurance trust?

It can provide a number of benefits. If you have substantial wealth, it may help shield your beneficiaries from having to pay estate taxes (or a portion of those taxes), helping to preserve family wealth across generations. It can also help ensure that your loved ones are taken care of when and how you want after you pass away, especially if they cannot manage assets on their own. Finally, when life insurance and other assets are placed in a trust, they bypass the often lengthy and burdensome probate process that ordinary wills are subjected to.

Why should you not put life insurance in a trust?

Generally speaking, once established, irrevocable trusts cannot be changed. So, for example, if you think you may need to access the cash value of your life insurance policy at some point in the future, then putting it in an irrevocable life insurance trust may not be your best option. A revocable trust can be changed, but there may be significant legal fees for doing so.  That’s why trusts are most often used by those with significant wealth and specific estate planning objectives, as opposed to others whose financial needs may change. 

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This article is for informational purposes only. Guardian may not offer all products discussed. Please consult with a financial professional to understand what life insurance products are available for sale.

1 Some whole life polices do not have cash values in the first two years of the policy and don’t pay a dividend until the policy’s third year. Talk to your financial professional and refer to your individual whole life policy illustration for more information.

Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59 ½, any taxable withdrawal may also be subject to a 10% federal tax penalty.

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