Life Insurance Benefits: Trust Funds Explained

Life insurance is a financial product that offers peace of mind to those who worry about what will happen to their dependents when they die. However, the payout on a life insurance policy may not always be tax-exempt, and this is where a trust comes in. A trust is a legal entity that owns assets on behalf of another person. When it comes to life insurance, a trust can ensure that the payout is distributed according to the policyholder's wishes and can also provide tax benefits. So, can a life insurance benefit be put into a trust? The short answer is yes, and there are several reasons why someone might choose to do this.

Pros and cons of life insurance in trust

A trust is a simple legal arrangement that lets you leave the money from your life insurance to whoever you choose as beneficiaries. It gives you more control over your life insurance payout and helps your beneficiaries legally avoid paying inheritance tax.

Pros

• Protection from inheritance tax: By putting your life insurance policy in trust, you can protect your pay-out from inheritance tax, so your loved ones receive more of the money, and faster.
• Choose your beneficiaries: You can choose exactly who gets the money and when. For example, you can appoint a trustee to look after the money if a child is under the age of 18.
• Faster payouts: Life insurance money held in trust doesn't need to go through probate, so the time it takes to make payments to your beneficiaries should be quicker.
• Free to set up: It doesn't usually cost anything extra to set up a trust. Your insurance provider will often help you set it up, and many providers have templates on their websites that you can use.

Cons

• Lack of control: Once you put your life insurance policy in trust, you're essentially handing over legal ownership to a trustee, and this decision is irreversible.
• Legal and tax implications: There are many legal and tax implications to consider when setting up a trust, and it can be difficult to make changes once it's been set up.
• Risk of invalidating insurance: There may be rare circumstances when you can amend a trust, but you could end up invalidating your life insurance.
• Seven-year rule: If you change your beneficiary and pass away less than seven years later, or if your new beneficiary isn't a spouse or civil partner, inheritance tax may be due.

How to set up life insurance in trust

Setting up life insurance in trust can be beneficial as it gives you more control over your life insurance payout. It also ensures that your beneficiaries do not have to pay inheritance tax on the life insurance payout.

Step 1: Determine the type of trust

There are two common types of life insurance trusts: irrevocable and revocable. Irrevocable Life Insurance Trusts (ILIT) cannot be changed, altered or revoked, while Revocable Life Insurance Trusts (RLIT) can be. Considering your financial situation and estate planning goals will help determine the right type of trust for your needs.

Step 2: Choose the life insurance trust beneficiaries

Once you've selected the type of trust, you'll need to choose who will benefit from the policy. Consider which family members or heirs should receive the proceeds and how much each will get. The trust can also specify how the money should be used, such as for college tuition, medical expenses or other financial obligations.

Step 3: Calculate the amount of insurance needed

The next step is to calculate your life insurance needs. You can use a life insurance calculator or the DIME method, which considers debts, income, mortgage and education. The amount of life insurance you need will depend on your family's current and future finances.

Step 4: Select the type of life insurance

When establishing a life insurance trust, it is generally best to use a permanent life insurance policy that doesn't expire. However, if cost is a concern, a term life insurance policy will be more affordable and can still provide significant benefits to the trust.

Step 5: Purchase the life insurance

Shop around for life insurance quotes and consider the policy fees and the growth rate of your cash value. Work with a financial advisor or life insurance agent to understand the costs of the policy beyond the premium quote. You'll also need to name the trust as the beneficiary of your life insurance policy to ensure the proceeds are paid directly to the trust.

Step 6: Transfer ownership of the policy to the trust

This step involves transferring ownership of your life insurance policy to the trust. The grantor (the life insurance policyholder) will need to sign a form from the insurance company and provide information about the trust. This step is often completed with the help of an experienced estate planning attorney, who can ensure that all legal documents and paperwork are filed correctly. Once ownership is transferred, the trust is responsible for making premium payments, claiming the death benefit and managing all aspects of the policy.

Types of trusts for life insurance

There are two main types of trusts for life insurance: irrevocable and revocable. Here is a detailed overview of each type:

Irrevocable Life Insurance Trusts (ILIT)

Irrevocable life insurance trusts are permanent and cannot be changed, altered, or revoked once they are set up. This type of trust offers protection from creditors and shields assets from estate taxes, making it ideal for individuals with a high net worth. The trust owns the life insurance policy, and the proceeds are not considered part of the grantor's estate, resulting in tax advantages. However, it's important to note that establishing an ILIT involves a significant amount of time and money, and the lack of flexibility may be a drawback for some.

Revocable Life Insurance Trusts (RLIT)

In contrast to ILITs, revocable life insurance trusts can be changed, altered, or revoked by the grantor at any time. Also known as living trusts, RLITs offer flexibility and control over the life insurance policy. However, they do not provide the same tax advantages as ILITs. Since the grantor retains ownership, the policy is considered part of their estate, and estate taxes may apply upon their death. RLITs are better suited for individuals or families whose needs may change over time.

In addition to the main types of trusts, there are a few other variations to consider:

• Absolute or Bare Trust: This type of trust allows beneficiaries who are 18 or older (or 16 or older in Scotland) to access the assets directly. While trustees can decide how to distribute income and, in some cases, capital, the beneficiaries cannot be changed.
• Discretionary Trust: This type of trust is useful when beneficiaries may not be capable of managing their money effectively. Trustees can make payout decisions with guidance from a 'letter of wishes' written by the grantor. Beneficiaries can be added or changed, providing flexibility.
• Flexible Trust: With a flexible trust, the chosen beneficiary receives the life insurance payout upon the grantor's death, and the grantor can specify how the money should be distributed. This type of trust allows for the separation of life insurance and critical illness policies, ensuring that the illness payout does not impact the life insurance funds managed by trustees.
• Survivor's Discretionary Trust: This type of trust is designed for cohabiting couples with joint life insurance policies. If one partner dies, the other inherits the life insurance payout before other beneficiaries. If both partners die within 30 days of each other, the payout goes to the other beneficiaries. A survivor's discretionary trust also helps unmarried couples avoid inheritance tax as the payout is not considered part of either partner's estate.

When to use a trust for life insurance

Life insurance offers your dependents or beneficiaries financial support when you die, either by paying out a lump sum or regular payments. The amount they receive depends on your policy. You can also choose to use the money as you wish, including to cover a mortgage or leave it as an inheritance.

There are many things to consider with your finances, but one of the biggest is who will receive your life insurance payout and how they will receive it without incurring a hefty inheritance tax bill. One way to do this is by putting your life insurance in trust.

Life insurance in trust can give you more control over your life insurance payout and help your beneficiaries legally avoid paying inheritance tax. It can also offer a quicker payout as you won’t have to go through probate, which can take months.

If you own a life insurance policy, you probably know that the beneficiaries you’ve named will receive the insurance proceeds when you pass away, and this money is income tax-free. However, the payout on a life insurance policy may not be exempt from estate tax, which is why planners often recommend that a trust own your life insurance policy instead of you owning it.

If you’re married and you name your spouse as the beneficiary of a life insurance policy that you own, there’s no estate tax on the insurance proceeds when you pass away because the payment to your spouse qualifies for the unlimited marital deduction from estate tax. When your spouse eventually passes away, however, any proceeds still in their name are subject to estate tax. An insurance trust can be an easy way to shelter the insurance proceeds from eventual estate taxes and prevent them from pushing your spouse’s estate value over the exemption threshold.

If you aren’t married, or if you and your spouse have a policy that only pays out on the death of the second spouse (a survivorship or second-to-die policy), having a trust as the policy owner can protect the insurance proceeds from estate tax on the death of your survivor.

If your estate exceeds your state's estate tax exemption threshold, it may be wise to place your ownership of any life insurance in an irrevocable life insurance trust (ILIT). Proceeds of a death benefit payout will not be included as part of your taxable estate if a trust, not an individual, owns the policy.

In most cases, it makes better sense to name your beneficiaries individually on life insurance policies versus naming a trust as a beneficiary. If your beneficiaries have creditor issues, suffer from mental health problems, can't be trusted with large sums of cash, or have primary beneficiaries who are minors or have drug issues, or if other unique scenarios apply, then naming a trust as the beneficiary might be a better route.

Tax and legal implications of life insurance in trust

When it comes to life insurance, there are several tax and legal implications to consider when setting up a trust. Firstly, let's understand the concept of a trust. A trust is a legal arrangement where you give your assets to a trusted individual or entity, known as a trustee, to manage and protect those assets for the benefit of your chosen beneficiaries. Now, let's explore the tax and legal implications of life insurance in trust:

Tax Implications:

• Inheritance Tax: One of the main advantages of placing your life insurance in a trust is that it helps your beneficiaries legally avoid paying inheritance tax. In the UK, for example, inheritance tax is typically charged at 40% on estates valued at more than £325,000. By setting up a trust, the life insurance payout is not considered part of your estate, reducing the tax burden on your beneficiaries.
• Gift Taxes: When setting up a trust, you may need to consider gift tax implications. Transferring the ownership of your life insurance policy to a trust is considered a gift. In some jurisdictions, such as the US, there is an annual gift tax exclusion limit, which is $18,000 in 2024. Any gifts above this amount may need to be reported and could impact your lifetime gift tax exemption.
• Income Tax: In some cases, if the proceeds of the life insurance payout remain in the trust and generate investment income, that income could be subject to taxation. It is important to seek professional tax advice to understand the specific rules in your jurisdiction.

Legal Implications:

• Loss of Control: When you place your life insurance in a trust, you are essentially transferring the legal ownership to the trustees. This means you give up control over the policy, and this decision is usually irreversible.
• Trustee Responsibilities: Trustees have important legal responsibilities, including managing the trust assets, making distributions to beneficiaries, and complying with applicable laws and regulations. It is crucial to select trustees who are reliable and understand their duties.
• Probate Process: Life insurance in trust can often expedite the payout process by avoiding the probate process, which can be lengthy. The trustees can ensure a quicker distribution of the insurance proceeds to the beneficiaries, usually within a few weeks.
• Invalidating Insurance: In rare circumstances, amending the trust or changing trustees may invalidate your life insurance policy. It is important to carefully review the terms and conditions of your policy and seek legal advice before making any changes.
• Seven-Year Rule: In certain jurisdictions, such as the UK, there is a seven-year rule to consider. If you change the beneficiary of your life insurance policy and pass away within seven years, inheritance tax may still be due, especially if the new beneficiary is not a spouse or civil partner.

It is important to note that tax and legal implications may vary depending on your location and specific circumstances. Always seek professional tax and legal advice to ensure you understand the implications of setting up a life insurance trust.

Frequently asked questions