Trusts And Life Insurance: A Smart Combination?

A life insurance trust is a legal agreement that allows a third party to manage the death benefit from a life insurance policy. There are two types of life insurance trusts: irrevocable life insurance trusts (ILIT) and revocable life insurance trusts. In the case of an ILIT, the trust owns the policy and the proceeds are not subject to federal estate tax. This is particularly beneficial for high-net-worth individuals whose estates exceed the federal estate tax threshold. On the other hand, a revocable trust offers more flexibility and control, but the death benefit value of the life insurance will be included in the grantor's gross estate for estate tax purposes. Setting up a life insurance trust can be complicated and costly, so it is generally recommended for those with a high net worth, young children, or special circumstances such as a beneficiary with special needs.

Irrevocable life insurance trusts (ILIT)

An irrevocable life insurance trust (ILIT) is a trust that cannot be amended or rescinded after its creation. Life insurance policies are the main assets held in ILITs.

ILITs offer several benefits. Firstly, they can help beneficiaries avoid estate taxes. In the US, proceeds from a life insurance policy paid to an individual are considered part of the taxable estate of the decedent. However, if a trust owns the policy, the proceeds are not included in the taxable estate. This is especially beneficial for people in states with lower estate tax exemption thresholds. Secondly, ILITs can protect beneficiaries who are financially irresponsible or have creditor issues. An appointed trustee can supervise the trust and distribute assets according to the grantor's wishes, ensuring that the benefits are used responsibly.

There are some drawbacks to ILITs. The benefactor loses control of the assets before death as changes to the trust can only be made by the beneficiaries. Additionally, while ILIT assets are not taxed as part of the benefactor's estate, they are taxed as part of the beneficiaries' estates, leaving a larger tax burden for descendants. The creation of an ILIT also involves complex paperwork that must conform to strict IRS guidelines, so it is essential to consult with a specialist lawyer or tax advisor.

Revocable life insurance trusts

A revocable trust is a trust that can be altered or cancelled by its creator depending on their changing needs or circumstances. A revocable life insurance trust is a legal entity that owns a life insurance policy, and it can be changed or revoked by the grantor.

Life insurance policies are protected from creditors in most US states, but the tax treatment is a complex issue. If your estate exceeds your state's estate tax exemption threshold, it may be a good idea to place your ownership of any life insurance in an irrevocable life insurance trust. This is because proceeds from a death benefit payout will not be included as part of your taxable estate if a trust, not an individual, owns the policy. For example, the federal estate tax exemption is $12.06 million for 2022 and $12.92 million for 2023, but Oregon's estate tax exemption is only $1 million.

If you already have a life insurance policy, you can change ownership from your name to your insurance trust. You would need to work with an estate planning attorney to create the trust document, and consider who will act as the trustee and the circumstances under which beneficiaries will have access to the insurance proceeds. Once the insurance trust document is drafted and signed, you can transfer ownership of the policy to the trust.

However, there are a few important considerations. Firstly, you must survive for more than three years from the date you transfer the policy into the trust, otherwise, the life insurance amount will be included in your estate for estate tax purposes. Secondly, the transfer of the policy into the trust is considered a gift and may use up a portion of your gift tax exemptions.

Estate planning

When considering estate planning, it is important to understand the two types of life insurance trusts: irrevocable and revocable. An irrevocable life insurance trust (ILIT) is a permanent arrangement where assets cannot be removed or changed. This type of trust is commonly used by high-net-worth individuals as it helps shield their estates from federal estate taxes. By placing the life insurance policy in an ILIT, the proceeds are not considered part of the individual's taxable estate, which can result in significant tax savings. However, it is important to note that establishing an ILIT involves a significant amount of time and money, and the three-year survival period after transferring the policy to the trust must be considered.

On the other hand, a revocable life insurance trust offers more flexibility and control. This type of trust can be amended or revoked at any time, making it a good option for those who want to maintain control over their assets. Revocable trusts are particularly useful for parents who want to structure benefit payments to their children, ensuring they receive their inheritance in instalments rather than a lump sum. Additionally, revocable trusts can help individuals who may become incapacitated, as a successor trustee can administer the policy on their behalf.

When deciding whether to set up a life insurance trust, it is essential to seek professional advice. Estate planning attorneys and financial advisers can provide guidance based on your specific circumstances, goals, and tax considerations. They can assist in determining if a trust is necessary and which type of trust aligns best with your needs. Additionally, they can help navigate the complex legal and tax requirements associated with establishing and maintaining a trust.

In conclusion, life insurance trusts are a valuable tool in estate planning, offering control, protection, and potential tax advantages. By understanding the differences between irrevocable and revocable trusts, individuals can make informed decisions about how to manage their life insurance policies effectively as part of their overall estate plan.

Tax treatment

The tax treatment of life insurance policies held in trust is a complex issue, and it's important to seek professional advice to understand how it applies to your specific circumstances. Here are some key considerations regarding the tax treatment of life insurance trusts:

Estate Taxes

One of the primary reasons for placing a life insurance policy into an irrevocable trust is to minimise estate taxes for your family. When you own a life insurance policy, the payout may be subject to estate tax, which can significantly reduce the amount your beneficiaries receive. By contrast, when a trust owns the policy, the proceeds are generally not considered part of your estate, and therefore, they are not subject to estate taxation. This can result in substantial tax savings, especially for high-net-worth individuals.

Income Taxes

In most cases, the beneficiaries of a life insurance policy receive the insurance proceeds tax-free. However, if the trust is the beneficiary, the proceeds may be subject to income tax. This is because trusts are not considered individuals for tax purposes, and the payout may be treated as taxable income. Therefore, it is generally more advantageous from a tax perspective to name specific individuals as beneficiaries rather than the trust itself.

Gift Taxes

When transferring a life insurance policy into an irrevocable trust, it is important to consider the gift tax implications. The transfer of the policy into the trust is typically considered a gift, and it may utilise a portion of your lifetime gift tax exemption. Additionally, if the policy has accumulated cash value, there may be gifting problems if the value exceeds the annual exclusion limit. To avoid gift taxes, it is crucial to work with an attorney and tax advisor to structure the transfer properly and take advantage of applicable exclusions and exemptions.

Inheritance Tax

Life insurance proceeds held in trust are generally protected from inheritance tax, which can be a significant benefit for your beneficiaries. The standard inheritance tax rate is typically around 40%, and by placing the policy into trust, you can ensure that your beneficiaries receive the full payout without incurring this substantial tax liability. This is especially relevant if your estate exceeds the inheritance tax threshold, as it can help your beneficiaries avoid a hefty tax bill.

Tax on Trust Income

While the proceeds from a life insurance policy held in trust are generally not subject to taxation, any investment income earned by the trust on those proceeds could be taxed. If the proceeds remain in the trust and generate investment income, such as interest or dividends, those earnings may be subject to income tax. Therefore, it is important to consider the ongoing tax implications for the trust and its beneficiaries.

Beneficiaries

When it comes to beneficiaries, it is important to always name a beneficiary when setting up a life insurance policy. While most policies have default beneficiaries, usually the insured's estate, this means that the policy will have to go through probate and be distributed to the insured's heirs-at-law. This can be costly and time-consuming, and the insured's minor children will not be able to access the funds until they are 18 years old.

The most common beneficiary structure is the insured's spouse, followed by children. However, it is important to note that minor children should not be named as beneficiaries, as they will not be able to access the funds until they are legally adults. Instead, the probate court will supervise the funds until they come of age.

To avoid probate, one option is to set up a revocable living trust and name it as the beneficiary of your life insurance policy. This gives you more control over how the proceeds are distributed and ensures privacy, as the details of the policy and its value are not made public. A trust can also protect the proceeds from creditors, lawsuits, divorces, or other financial setbacks that your beneficiaries may face in the future.

Another option is to set up an irrevocable life insurance trust (ILIT), especially if your estate is larger than your state's estate tax exemption threshold. By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 40%. However, note that revocable trusts do not qualify for this exclusion.

When deciding whether to name a trust or individuals as beneficiaries, it is important to consider the tax implications and the unique circumstances of your beneficiaries. If your beneficiaries have creditor issues, mental health problems, or addiction problems, or if they are minors, naming a trust as the beneficiary might be preferable. This allows you to stipulate how the funds should be distributed and used.

Additionally, consider consulting with professionals such as an estate planning attorney, a financial advisor, and a tax advisor to ensure that your beneficiary designations align with your goals, meet legal requirements, and take into account any tax implications.

Frequently asked questions