Trusts: Can They Be Life Insurance Beneficiaries?

Life insurance is a crucial financial product that provides peace of mind and financial security for individuals and their loved ones. One of the essential aspects of a life insurance policy is designating a beneficiary who will receive the benefits in the event of the policyholder's death. While most people typically choose their spouse or partner as the primary beneficiary, there may be instances where a trust is named as the beneficiary. This approach offers several advantages and complexities that individuals should carefully consider.

Pros of listing a trust as beneficiary

Yes, a trust can be listed as a beneficiary of a life insurance policy. Here are some pros of listing a trust as a beneficiary:

Probate Avoidance

Probate is a lengthy and costly process of proving and distributing an estate to heirs. By listing a trust as a beneficiary, you can avoid probate, ensuring that the money intended for your children's care reaches them without delay.

Control and Protection

A trust allows you to specify how the life insurance proceeds should be distributed and when. This is especially beneficial if you want to ensure your children are cared for according to your wishes, even if you are not there to oversee it. It also allows you to protect the proceeds from creditors, lawsuits, or other financial setbacks your beneficiaries may face.

Estate Planning Efficiency

Listing a trust as a beneficiary integrates your life insurance policy into your overall estate plan, ensuring that the proceeds are distributed according to your wishes and estate planning objectives.

Privacy

When a trust is named as a beneficiary, the details of the life insurance policy, its value, and the distribution plan remain private and are not subject to public scrutiny.

Cons of listing a trust as beneficiary

Yes, a trust can be a life insurance beneficiary.

It can be pricey to set up:

Setting up a revocable living trust can be costly and time-consuming. Costs may include expenses related to setting up deeds and transferring ownership, as well as legal fees.

Additional estate planning is needed:

To set up a trust, you need to have a will in place. Heirs can contest a trust for longer than a traditional will, usually between one to five years depending on the location.

Unfavourable tax consequences:

Trusts are not considered individuals, so they may be subject to estate taxes. For example, retirement plan assets will be subject to required minimum distribution payouts based on the oldest beneficiary's life expectancy.

Complicated process:

Listing a trust as a beneficiary can be complicated due to legal and taxation reasons. It is important to consult with an estate planning attorney and financial advisor to ensure the trust aligns with your goals and meets legal requirements.

Loss of flexibility:

Once an irrevocable trust is set up, it cannot be changed, even in the case of a divorce or a change in preference for the beneficiary.

While there are some drawbacks to listing a trust as a beneficiary, it can be a beneficial option for those with specific concerns, such as minor children or beneficiaries with creditor issues. It provides control over the distribution of assets and helps to avoid probate.

Irrevocable vs revocable trusts

Trusts are a popular tool for estate planning and for simplifying the transfer of assets between generations. There are two main types of trusts: revocable trusts and irrevocable trusts. Both types of trusts provide control over asset management and protection against probate court, but they differ in terms of flexibility and tax protection.

Revocable Trusts

A revocable trust, also known as a living trust, is a trust in which the terms can be changed at any time. The owner of a revocable trust may change its terms, remove or add beneficiaries, and modify stipulations on how assets within the trust are managed. Revocable trusts are easier to set up than irrevocable trusts, and they can be amended, saving time and money. However, they do not minimize estate taxes and are not shielded from creditors.

Irrevocable Trusts

As the name suggests, an irrevocable trust is a trust that cannot be modified after it is created without the beneficiaries' consent or court approval, or both. Irrevocable trusts offer estate tax benefits that revocable trusts do not, and they may be good for individuals whose jobs may make them at higher risk of a lawsuit. Irrevocable trusts can be difficult to set up and require the help of a qualified trust attorney. The grantor cannot be a trustee, and irrevocable trusts may be subject to higher income tax rates than individual income tax rates.

Estate planning efficiency

Naming a trust as a beneficiary can help streamline the estate planning process by integrating the life insurance policy into the overall estate plan, ensuring that the proceeds are distributed according to the grantor's wishes. This allows for more complex plans for distribution, such as specific gifts to friends and family or unequal percentages to multiple beneficiaries. It also enables the grantor to retain control over how the proceeds are managed and distributed after their death, which is especially important if the beneficiaries are minors or young adults.

Additionally, naming a trust as a beneficiary can help avoid probate, a costly and time-consuming legal process that can delay the distribution of assets to heirs. Probate may also result in a notable chunk of the life insurance payout being lost to legal fees, debts, or taxes. By naming a trust as a beneficiary, the distribution of proceeds remains private and is not subject to public scrutiny.

However, it is important to note that listing a trust as a beneficiary can add complexity to the distribution process, as the trustee will be responsible for managing and disbursing the proceeds according to the trust's terms. This may also result in a longer wait time for the payout to be received by the beneficiaries.

Overall, naming a trust as a beneficiary of a life insurance policy can be a strategic move in estate planning, providing probate avoidance, control, protection, and privacy. However, it is crucial to seek professional legal and financial advice to navigate the complexities involved and ensure that the decision aligns with the grantor's long-term financial goals and provides lasting security for the beneficiaries.

Tax treatment of proceeds

The tax treatment of proceeds is a complex issue that depends on several factors, including the type of trust, the beneficiary, and the state of residence. Here is an overview of the key considerations:

Taxation of Life Insurance Proceeds for Trusts

The taxation of life insurance proceeds can be different for trusts compared to individuals. While life insurance proceeds are generally income tax-free for beneficiaries, this may not be the case for trusts. Trusts are not considered individuals, and life insurance proceeds paid to trusts are typically subject to estate tax. The estate tax treatment depends on the type of trust and the state of residence.

Irrevocable Life Insurance Trust (ILIT)

If the trust is an irrevocable life insurance trust (ILIT), the proceeds of a death benefit payout will not be included in the taxable estate, potentially reducing estate taxes. This is because the trust, not an individual, owns the policy. However, this exclusion does not apply to revocable trusts. To qualify for the exclusion, it is essential to survive for more than three years after transferring the policy to the ILIT. Otherwise, the life insurance amount will be included in the estate for estate tax purposes.

Federal and State Estate Taxes

The federal estate tax exemption was $12.06 million for 2022 and increased to $12.92 million for 2023. However, it's important to note that some states have much lower estate tax exemption thresholds. For example, Oregon's estate tax exemption is only $1 million. Therefore, it is crucial to consider the state-level estate tax when deciding whether to place a life insurance policy in a trust.

Spousal Beneficiaries

If the life insurance beneficiary is a spouse, assets can generally be transferred estate-tax-free, regardless of the amount, as long as the spouse is a U.S. citizen. However, when the surviving spouse passes away, any remaining proceeds in their name become subject to estate tax. Placing the policy in an ILIT can help shelter the insurance proceeds from estate taxes and prevent the spouse's estate value from exceeding the exemption threshold.

Tax Implications for Individual Beneficiaries

In most cases, naming beneficiaries individually on life insurance policies is more straightforward than naming a trust as the beneficiary. For federal tax purposes, if a spouse is named as the beneficiary, the life insurance proceeds are generally income- and estate-tax-free when paid as a lump sum. However, if the beneficiaries have creditor issues, mental health problems, or other specific circumstances, naming a trust as the beneficiary may be preferable.

Tax Considerations for Trust Beneficiaries

When a trust is named as the beneficiary, the distribution of life insurance proceeds remains private and is not subject to probate. This allows for control over how the proceeds are distributed. Additionally, depending on the type of trust, the proceeds may be protected from creditors, lawsuits, or other financial setbacks that beneficiaries may face.

The tax treatment of life insurance proceeds for trusts and beneficiaries depends on various factors. While placing a life insurance policy in a trust can offer tax advantages, particularly for high-net-worth individuals, it is important to seek professional advice to navigate the legal and tax complexities involved.

Frequently asked questions