Trusts And Life Insurance: Can They Co-Exist?

A revocable trust can be used to own life insurance or be the beneficiary of a life insurance policy. The benefit of the revocable trust holding the life insurance is that if the owner becomes incapacitated, a successor trustee will be able to keep administering the life insurance policy on their behalf. In addition, a revocable trust gives the owner a lot of flexibility and control over an irrevocable trust. However, the death benefit value of the life insurance will be included in the owner's gross estate for estate tax purposes.

Revocable vs. irrevocable trusts

Revocable and irrevocable trusts are two of the most popular types of trusts used for estate planning. While both provide control over asset management and protection against probate court and privacy, 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. The trust can be amended several times within the trustee's lifetime, saving time and money. It also allows for continuous management of assets in the event of the trustee's incapacitation or death. The grantor (the trust creator) can be a trustee and can act as one during their lifetime, retaining control over the assets.

However, a revocable trust does not minimize estate taxes. If the grantor dies, the assets held in the trust are subject to state and federal estate taxes. It is also not shielded from creditors, meaning that if the grantor owes anything at the time of death, creditors can pursue the trust for those obligations.

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. The benefactor, having transferred assets into an irrevocable trust, effectively removes all rights of ownership and control over the assets. The trust, rather than the creator, is considered the owner of the assets and holds them for the benefit of the beneficiaries.

Irrevocable trusts minimize estate taxes since the assets are no longer considered the property of the grantor. They also protect assets from creditors, as the trust is protected from creditors and legal judgments. Irrevocable trusts can be beneficial for individuals in professions with a higher risk of lawsuits, such as medical professionals or lawyers.

However, irrevocable trusts are more complex and difficult to establish than revocable trusts, often requiring the help of a qualified trust attorney. The grantor must cede ownership and control of the assets to the trust, and it can be challenging to change the trust or access the assets if needed. Additionally, irrevocable trusts may be subject to higher income tax rates than individual income tax rates at the federal level.

In summary, the main difference between revocable and irrevocable trusts lies in their flexibility and tax implications. Revocable trusts offer the advantage of flexibility, allowing the grantor to retain control and make changes as needed. On the other hand, irrevocable trusts provide greater tax benefits and asset protection but are more complex and challenging to modify. The choice between the two depends on an individual's specific needs and circumstances, and it is recommended to consult a financial professional or attorney for guidance.

Tax implications

The tax implications of a revocable trust purchasing life insurance are complex and depend on various factors, including the state of residence, the size of the estate, and the beneficiaries involved. Here is an overview of the key tax considerations:

Tax Treatment:

The interaction between ownership, beneficiaries, and tax treatment in the context of life insurance and trusts can be confusing. It involves US ordinary income taxes for the beneficiary and federal estate taxes on the deceased's estate tax return.

Spousal Transfers:

In most cases, spouses can transfer assets, including life insurance proceeds, tax-free upon the death of one spouse. This applies as long as the surviving spouse is a US citizen. Therefore, naming a spouse as the primary beneficiary of a life insurance policy is generally a tax-efficient strategy.

Estate Tax Exemption Threshold:

If your estate exceeds your state's estate tax exemption threshold, consider placing your life insurance policy under an irrevocable life insurance trust (ILIT). This is particularly relevant in states with lower exemption thresholds, such as Oregon, which has a $1 million threshold. By using an ILIT, the proceeds from the life insurance payout will not be included in your taxable estate, which can be taxed at a rate as high as 40%. It's important to note that revocable trusts do not qualify for this exclusion.

Transfer Timing:

To avoid taxes on deathbed transfers, the government mandates that you must survive the transfer of assets to a trust by three years, or your estate will be taxed. Additionally, if the value of cashing in the policy before your death exceeds certain thresholds ($16,000 in 2022 or $17,000 in 2023), it may use up part of your gift and estate tax exemptions.

Naming Beneficiaries:

In most cases, it is more advantageous from a tax perspective to name beneficiaries directly on life insurance policies rather than naming a trust as the beneficiary. This is because proceeds paid to trusts are generally subject to estate tax, whereas proceeds paid to named beneficiaries are often exempt. However, if your beneficiaries have creditor issues, mental health problems, or issues with managing large sums of money, naming a trust as the beneficiary may be preferable to provide additional protection and control over how funds are distributed.

Tax Consequences for Trusts:

Trusts are not considered individuals for tax purposes, so they may be subject to estate taxes and other unfavourable tax consequences. For example, retirement plan assets distributed to a trust may be subject to required minimum distribution payouts based on the life expectancy of the oldest beneficiary.

Probate

In the context of life insurance and revocable trusts, probate can be avoided by naming a trust as the beneficiary of a life insurance policy. This is because life insurance policies are considered contracts, and the terms of a contract bypass probate and go directly to the assigned beneficiary. By contrast, if life insurance is payable to an estate, the proceeds are administered like any other asset subject to probate and are used to pay the decedent's debts.

While naming a revocable trust as the beneficiary of a life insurance policy can help avoid probate, it is important to note that revocable trusts do not protect heirs from estate taxes or claims from creditors. For this reason, irrevocable trusts are often recommended for estate tax planning purposes, as they are considered separate from the grantor's assets.

In summary, probate is a legal process of distributing a deceased person's assets, and it can be avoided by naming a trust as the beneficiary of a life insurance policy. However, the type of trust and other factors will determine the specific implications for probate and other tax considerations.

Trustee control

A revocable trust can be used to own a life insurance policy or be the beneficiary of the life insurance. The benefit of the revocable trust holding the life insurance is that if you were to become incapacitated, a successor trustee will be able to keep administering the life insurance policy on your behalf.

The revocable trust can also be used to provide flexibility and control over an irrevocable trust. It can be amended or revoked at any time, and taxes for the assets in the trust can be filed under the owner's social security number.

If you are well under the estate tax exemption amount, having a revocable trust to hold life insurance is one of the best tools you can have as it provides the most flexibility and you will not have to pay estate tax in the first place.

In the case of a couple, it is generally recommended to list a revocable trust as the primary beneficiary of a life insurance policy. This is because, in most cases, the surviving spouse will have full access to the money even if the trust is listed as the primary beneficiary. This ensures that the money is protected by a trust.

Additionally, if the trust inherits the death benefit of a life insurance policy, the trustee will be able to control how the money is handled according to the terms laid out in the trust. This can be beneficial if there are minor children or complex plans for distribution.

Estate planning

A revocable trust, also known as a living trust, offers flexibility and control during the grantor's lifetime. It can be amended or revoked at any time, providing the grantor with the ability to make changes as their circumstances evolve. In the context of life insurance, a revocable trust can be designated as the owner or beneficiary of the policy. This approach ensures that the death benefit proceeds are distributed according to the grantor's wishes, as outlined in the trust documents. It also allows for the management and control of assets, protecting beneficiaries from creditors and ensuring funds are used as intended.

However, it is important to note that the death benefit value of the life insurance policy will be included in the grantor's gross estate for estate tax purposes if a revocable trust is used. This means that the proceeds may be subject to taxation, depending on the applicable state and federal estate tax exemption thresholds. For individuals with a high net worth, this could result in significant tax liabilities for their estate.

To mitigate potential estate tax consequences, some individuals may consider using an irrevocable trust, such as an Irrevocable Life Insurance Trust (ILIT), as the owner and beneficiary of their life insurance policy. By doing so, the assets in the irrevocable trust are generally excluded from the grantor's gross estate for estate tax purposes, resulting in potential tax savings. However, it's important to seek legal and tax advice when considering this option, as it may not be suitable for everyone.

Ultimately, the decision to use a revocable or irrevocable trust as the beneficiary of a life insurance policy depends on an individual's unique circumstances and goals. It is essential to consult with a qualified estate planning attorney to understand the legal and tax implications of each option and make an informed decision that aligns with one's specific needs and objectives.

Frequently asked questions