Trustee And Beneficiary: Can One Person Play Both Roles?

Life insurance is a crucial financial product that provides financial support to dependents or beneficiaries upon the policyholder's death. While the policyholder's spouse is typically the primary beneficiary, certain circumstances may warrant designating a trust as the beneficiary. This arrangement offers several benefits, including tax advantages, protection against probate, and efficient asset transfer. However, it is essential to understand the legal and tax implications, as well as the potential drawbacks, such as the time and cost involved in setting up a trust. In Illinois, for instance, trustees play a critical role in managing life insurance proceeds within a trust, ensuring policy premiums are paid, and benefits are distributed according to the grantor's instructions. This article will explore the complexities of designating a trustee as the beneficiary of a life insurance policy, providing valuable insights for individuals seeking to navigate this important financial decision.

Pros and cons of a trust as beneficiary

When it comes to life insurance, a designated beneficiary is one of the most important parts of the policy. While a spouse is the most common choice, there are other options to consider, such as naming a trust as the beneficiary. This can be done to minimize taxes on life insurance benefits, but it is a complicated process with several pros and cons to consider.

Pros of listing a trust as the beneficiary:

• Sidestep probate: The probate process can be lengthy and expensive, delaying the delivery of benefits to the beneficiary. By naming a trust, you can avoid probate and ensure a quicker payout.
• Control: A trust allows you to specify how the insurance proceeds should be distributed and when. This is especially valuable if you have concerns about the financial responsibility of certain beneficiaries.
• Protection: A trust can protect the insurance proceeds from creditors, lawsuits, divorces, or other financial setbacks that beneficiaries may face.
• Estate planning efficiency: Naming a trust as the beneficiary can streamline the estate planning process, allowing for the integration of the insurance policy into the overall estate plan.

Cons of listing a trust as the beneficiary:

• Costly and time-consuming: Setting up a revocable living trust can be expensive and time-consuming, involving legal fees and other costs.
• Additional estate planning required: To set up a trust, you need to have a will in place. Heirs can contest a trust for longer than a traditional will, so it's important to seek professional guidance to ensure the trust aligns with your goals and legal requirements.
• Complexity: Naming a trust as the beneficiary adds complexity to the distribution process, with the trustee responsible for managing and distributing the proceeds according to the trust's terms.
• Tax implications: Different types of trusts have varying tax implications. Trusts are not considered individuals, so proceeds paid to trusts may be subject to estate tax.

Tax treatment of a trust as beneficiary

Trusts are often used to minimise the taxes on life insurance benefits. However, the process is complicated and there are some legal and tax implications to consider.

Revocable vs Irrevocable Trusts

A revocable trust can be modified or closed during the grantor's lifetime, whereas an irrevocable trust cannot be amended or closed after it has been opened. Revocable trusts are also known as living trusts and can be changed or revoked by the settlor during their lifetime without anyone's consent. Irrevocable trusts, on the other hand, are generally unable to be modified or revoked by the settlor once they have signed the trust agreement.

Tax Treatment of Trusts

The tax treatment of different types of trusts can vary significantly. Trusts are taxed more aggressively than individuals. Trusts are subject to income tax, capital gains tax, gift tax, estate tax, and property tax.

Income Tax

Trusts are treated as either grantor or non-grantor trusts for income tax purposes. In the case of a grantor trust, the grantor is responsible for paying the tax on income generated by trust assets. For non-grantor trusts, the beneficiaries are responsible for paying the income taxes on the income generated by trust assets, while the trust will pay the taxes on capital gains.

Capital Gains Tax

Capital gains taxes are levied on trusts when their investments, such as stocks and real estate, are sold for a higher value than their base price. Trusts that hold investments for longer than a year before selling will be subject to lower long-term capital gains tax rates.

Gift Tax

If an asset is transferred during the lifetime of one party to another without receiving fair market value in return, the person making the gift may be subject to a gift tax if the value of the asset exceeds the gift tax exclusion amount.

Estate Tax

Estate taxes are levied when assets are transferred from a deceased person to beneficiaries. Most trusts will not be responsible for paying estate tax as it is only levied on a decedent's assets valued above a certain threshold.

Property Tax

If a trust owns real estate, the trustee will have to pay county and state property taxes on each property.

Tax Forms for Trusts

Trustees need to submit a completed 1041 form (trust income tax return) to the IRS to deduct the income distributed to beneficiaries from the trust's taxable income. They also need to complete a K-1 form for each beneficiary, detailing the distribution's income and principal breakdown.

Tax Treatment of Trust Beneficiaries

Whether a beneficiary pays tax on a trust distribution depends on whether the distribution comes from the trust's principal or income. Beneficiaries are not taxed on distributions from the trust's principal but are taxed on distributions from the trust's income.

Irrevocable vs 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 beneficiaries, designate new ones, and modify stipulations on how assets within the trust are managed. Revocable trusts are easier to set up than irrevocable trusts and can be modified after they are created. However, because the owner retains such a level of control over a revocable trust, the assets they put into it are not shielded from creditors. When the owner of a revocable trust dies, the assets held in trust are also subject to state and federal estate taxes.

An irrevocable trust, on the other hand, is a trust that cannot be modified after it is created without the beneficiaries' consent or court approval, and possibly both. The benefactor, having transferred assets into an irrevocable trust, effectively removes all rights of ownership to the assets and, for the most part, all control. Irrevocable trusts offer estate tax benefits that revocable trusts do not. They may be good for individuals whose jobs may make them at higher risk of a lawsuit. Irrevocable trusts are also more difficult to set up than revocable trusts and require the help of a qualified trust attorney.

Both revocable and irrevocable trusts can be used to minimise taxes on life insurance benefits by making the trust a beneficiary of the policy. However, this process can be complicated and there are legal and tax implications to consider.

Estate tax considerations

Understanding Estate Taxes

Estate taxes are levied on the value of a person's estate upon their death. The estate includes all assets, such as property, money, investments, and life insurance payouts, as well as any outstanding debts. Each jurisdiction has different estate tax laws and exemption thresholds. In the US, the federal estate tax exemption was $12.06 million for 2022 and $12.92 million for 2023, with a top tax rate of 40%. However, some states have much lower exemption thresholds, such as Oregon's $1 million threshold.

Strategies to Minimise Estate Taxes

There are several strategies that individuals can employ to minimise the impact of estate taxes on their beneficiaries:

• Irrevocable Life Insurance Trust (ILIT): By placing a life insurance policy in an ILIT, the proceeds are excluded from the taxable estate. This is because the trust, not an individual, owns the policy. This strategy is particularly useful for individuals with large estates or those concerned about their beneficiaries' ability to manage taxes and finances. However, it's important to note that the grantor must survive the transfer by three years, or the estate will be taxed anyway.
• Spousal Transfer: In most jurisdictions, assets transferred between spouses are generally exempt from estate taxes, regardless of the amount, as long as the spouse is a citizen. This strategy can help delay the payment of estate taxes until the death of the surviving spouse.
• Gifting: Individuals can gift up to $16,000 per person in 2022 and $17,000 in 2023 without incurring gift taxes. This strategy can be used to reduce the value of an estate, potentially bringing it below the exemption threshold.
• Transfer of Ownership: Transferring ownership of a life insurance policy to another person or entity can help remove it from the taxable estate. However, the original owner must give up all rights to the policy, and the new owner must pay the premiums.
• Early Planning: It's important to plan ahead and seek professional advice. Estate planning attorneys and financial advisers can provide guidance on strategies to minimise estate taxes, such as trusts, gifting, and ownership transfers.

Control over proceeds

When a trust is the beneficiary of a life insurance policy, trustees play a critical role in managing the proceeds. They are responsible for overseeing policy premiums and disbursing benefits according to the grantor's instructions. This gives trustees a significant degree of control over the proceeds, which can be advantageous in certain situations.

One of the key benefits of having a trust as the beneficiary is the ability to control how the proceeds are distributed. Trustees can ensure that the money is used in accordance with the grantor's wishes, which can be especially important if the beneficiaries are minors or have special needs. For example, the grantor may specify that children receive a certain percentage of the assets at different ages, such as one-third at 21, two-thirds at 25, and the rest at 30. The trustee will have the discretion to pay out more if they believe it is in the child's best interests. This helps to prevent the money from being spent irresponsibly or misused.

Trustees can also ensure that the proceeds are protected from creditors and are not used to pay off the estate's debts. This can be an important consideration, especially if the estate is subject to high taxes or other financial obligations. By keeping the proceeds separate from the estate, trustees can ensure that they are used solely for the benefit of the intended beneficiaries.

In addition, having a trust as the beneficiary can help to avoid the probate process, which can be lengthy and expensive. The trustee can distribute the proceeds directly to the beneficiaries, bypassing the need for probate. This can result in a quicker payout, often within a few weeks, compared to the months it can take for probate to be completed.

However, there are also some potential drawbacks to consider. One downside is that receiving the payout may involve more paperwork and take longer if a trust is the beneficiary. This is because the trustee must provide certain documentation to the life insurance company, which can delay the process. Typically, a married person will name their spouse as the direct beneficiary to ensure a quick and straightforward payout, and then name the trust as the successor beneficiary for additional control and protection.

Another consideration is the cost and complexity of setting up a trust. It often requires the assistance of an estate planning attorney or financial adviser, and there may be associated expenses such as legal fees and costs related to transferring ownership. However, by setting up a trust, individuals can gain peace of mind knowing that their wishes will be carried out and their beneficiaries will be taken care of according to their instructions.

Frequently asked questions