Trust Funding: Life Insurance For Minors

Life insurance is a common way to fund a trust for minors, as it provides immediate liquidity to the trust and allows for greater control over how the assets are distributed and spent. This can be particularly beneficial for minors, as it ensures their needs are taken care of until they are old enough to assume control of the assets themselves. While there are some legal implications to consider when naming a minor as a beneficiary, it is possible to set up a trust with a designated trustee to manage the assets on their behalf.

The pros and cons of a life insurance trust

A life insurance trust is a legal entity that holds assets that are managed and distributed by a designated trustee. When the insured person dies, the trustee administers the trust on behalf of the beneficiary or beneficiaries. Here are some pros and cons of a life insurance trust:

Pros:

• Control: You can control when your children receive your life insurance death benefit, and even what they spend it on.
• Speed: If your children are minors when you die, the money from your policy's payout can benefit them faster. This is because trusts avoid probate, a lengthy legal process where the court oversees the distribution of your assets.
• Eligibility for government benefits: If you have children with disabilities, a special needs trust may help preserve their eligibility for certain government programs.
• Estate taxes: If you have millions of dollars in assets when you die, you may be able to avoid estate taxes that would otherwise be owed on your life insurance death benefit with an irrevocable life insurance trust.

Cons:

• Complexity: Setting up a life insurance trust involves paperwork, time and sometimes an estate planning attorney.
• Cost: You may pay up to thousands of dollars to set up a life insurance trust, depending on whether you do it yourself or hire an estate planning attorney.
• May be hard to change: Depending on how you set up your trust, you may not be able to alter it easily.
• Loss of control: As you're handing over the legal ownership of your life insurance in trust to a trustee, you'll have no control. This decision is irreversible.

How does a life insurance trust work?

A life insurance trust is a legal entity that holds assets that are managed and distributed by a designated trustee. It allows you to pass on money to your children smoothly after you die, according to your wishes. It can also help you avoid estate taxes on your life insurance death benefit if you have millions in assets.

Here's how a life insurance trust works:

Create a trust agreement:

The first step is to create a trust agreement, where you name the trust's beneficiaries (such as your children) and provide instructions for how you want the life insurance policy's death benefit to be managed or distributed after your death. You can also specify the age at which your children will receive the payout, which is usually 18 or 21, depending on the state.

Name a trustee:

Next, you need to name one or more trustees. Trustees are responsible for managing the trust while you are alive and distributing the assets after your death, according to the guidelines you set out in the trust agreement. Trustees have a fiduciary duty, which means they must act in the best interest of the trust's beneficiaries. The trustee can be a trusted relative, partner, friend, legal representative, or another adult. You can also name yourself as the primary trustee and designate a "successor" trustee to take over after your death.

Name the trust as the beneficiary:

The third step is to name the trust as the beneficiary on your life insurance policy. This way, the trustee will be able to collect, manage, and distribute the policy's death benefit according to your wishes. You can also name the trust as a backup beneficiary if you want your spouse or partner to be the primary beneficiary.

Pay the life insurance premiums:

You will need to continue paying the life insurance premiums to keep the policy active. If you have transferred ownership of the policy to the trust, the trustee will be responsible for paying the premiums on your behalf. You can fund the trust by sending money as a gift, which the trustee can then use to make the premium payments.

Seek professional help:

Setting up a life insurance trust can be complicated, so it is recommended to consult an estate planning attorney or use an online estate planning service for guidance. They can help you navigate the legal and financial complexities involved in establishing the trust.

Types of life insurance trusts

There are two primary types of life insurance trusts: revocable and irrevocable.

Revocable Life Insurance Trusts (RLIT)

A revocable life insurance trust, also known as a living trust, gives you the flexibility to make changes to it at any time and even cancel it if you decide you no longer need it. For instance, if your children are older and you feel they will use the life insurance policy's death benefit responsibly. With revocable trusts, you usually name yourself as a trustee and name a co-trustee or successor trustee to take over when you die. While you retain complete control over the trust and life insurance policy while you're alive, setting up a revocable trust can be confusing and costly.

Irrevocable Life Insurance Trusts (ILIT)

An irrevocable life insurance trust is a trust that cannot be changed or cancelled easily once finalised. High-net-worth individuals typically use ILITs to minimise federal and state estate taxes and, in some cases, shield a life insurance policy's death benefit from creditors or future lawsuits. Irrevocable trusts are intended to be permanent, but you may be able to change one under rare circumstances if you get written consent from all trustees and beneficiaries.

The upside of an ILIT is that you can avoid paying estate taxes on your life insurance death benefit. The downside is that you can't easily change an ILIT after it's established.

Why fund a trust with life insurance?

There are several reasons why you may want to use life insurance to fund a trust. Here are some key advantages:

Peace of Mind and Security for Your Family

A trust can be a powerful tool to secure your family's future and ensure they are taken care of according to your wishes, even after you're gone. It provides guidelines for executing your will, ensuring your assets are managed and distributed with care and intention.

Control and Flexibility

By setting up a life insurance trust, you can control how and when your beneficiaries receive the death benefit. You can also specify how the money should be used, such as for college tuition, medical expenses, or other financial obligations. This level of control is especially important if you have young children or beneficiaries with special needs.

Avoiding Legal Complications

Naming a minor as a direct beneficiary of a life insurance policy can lead to legal complications. Insurance companies cannot give payouts directly to minor children. By placing the insurance benefit in a trust, you can avoid these complications and ensure that your wishes are carried out smoothly.

Tax Benefits

Life insurance trusts can provide tax advantages, depending on the type of trust. With an irrevocable insurance trust, the death benefit is generally not included in the grantor's taxable estate, potentially reducing estate taxes. Additionally, beneficiaries typically don't pay income taxes on irrevocable life insurance trust proceeds.

Asset Protection and Avoiding Probate

Irrevocable insurance trusts protect the death benefit from creditors and judgments. Life insurance-funded trusts also bypass probate, saving time and money for beneficiaries by avoiding the lengthy legal process where the court oversees the distribution of assets.

Liquidity and Immediate Access to Funds

Life insurance policies can be immediately liquidated, providing your family with quick access to funds to cover major expenses. This liquidity can also help pay estate taxes without the need to dissolve other assets, such as real estate or a business.

How to fund a trust with life insurance

Funding a trust with life insurance is a great way to secure your family's future. Here's a step-by-step guide on how to do it:

Determine the type of trust:

There are two common types of life insurance trusts: irrevocable and revocable. Irrevocable trusts cannot be changed, altered, or revoked, and they offer protection from creditors and estate taxes. On the other hand, revocable trusts offer more flexibility as they can be changed or revoked at any time but don't have the same tax advantages.

Choose the beneficiaries:

Decide who will benefit from the policy and how much each beneficiary will receive. You can also specify how the money should be used, such as for college tuition or medical expenses. If you have a child with special needs, consider setting up a special needs trust within the life insurance trust to ensure they continue receiving government benefits.

Calculate the amount of insurance needed:

Figure out how much coverage you need by considering your family's current and future finances. Take into account factors such as inflation, estate taxes, funeral costs, and potential legal costs associated with administering the trust.

Select the type of life insurance:

It is generally recommended to use a permanent life insurance policy that doesn't expire for a life insurance trust. However, if cost is a concern, a term life insurance policy is a more affordable option that can still provide significant benefits.

Purchase the life insurance:

Shop around for life insurance quotes and consider policy fees and the growth rate of the cash value. Work with a financial advisor or life insurance agent to understand the full costs of the policy beyond the premium quote. Remember to name the trust as the beneficiary of your life insurance policy.

Transfer ownership of the policy to the trust:

This step usually involves signing a form from the insurance company and providing information about the trust. It is often completed with the help of an experienced estate planning attorney, who ensures that all legal documents and paperwork are filed correctly.

By following these steps, you can effectively fund a trust with life insurance, ensuring that your beneficiaries receive the intended benefits and that your wishes are carried out.

Frequently asked questions