Adjusting Life Insurance In A Trust: Can You?

Life insurance policies are often used to provide financial support to dependents or beneficiaries after the policyholder's death. However, the payout may be subject to estate tax, which can reduce the amount of money that beneficiaries receive. One way to avoid this tax is to place the policy in a trust, which is not considered part of the estate. This can be done by changing the ownership of the policy to the trust or by naming the trust as the beneficiary. While this can be an effective strategy for minimising taxes, there are also legal and tax implications that should be carefully considered beforehand.

Irrevocable vs revocable trusts

Trusts are a popular estate-planning tool for simplifying the transfer of assets between generations. Revocable and irrevocable trusts both provide control over asset management and protection against probate court and privacy, but they differ significantly 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 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, but they do come with some disadvantages. Because the owner retains control over a revocable trust, the assets they put into it are not shielded from creditors, and if they are sued, the trust assets can be liquidated to satisfy any judgment put forth. When the owner of a revocable trust dies, the assets held in trust are subject to state and federal estate taxes.

Irrevocable Trusts

Irrevocable trusts, on the other hand, cannot be modified after they are created, or at least doing so is very difficult. The terms of an irrevocable trust are set in stone once the agreement is signed, and changes would require the consent of its beneficiaries or a court order, or both. Irrevocable trusts offer estate tax benefits that revocable trusts do not, and they may be good for individuals whose jobs may make them at higher risk of a lawsuit. However, they are more complicated to set up and require the help of a qualified trust attorney.

Whether a revocable or irrevocable trust is better depends on your individual circumstances. If you want control and flexibility over the trust and have relatively basic needs, a revocable trust is likely the best option. However, if asset protection and estate tax mitigation are more important to you, then an irrevocable trust is probably the better choice. It's also worth noting that you can have both types of trusts if you have the resources.

Tax implications

The tax implications of changing the amount on a life insurance policy in a trust depend on several factors, including the type of trust, the beneficiary, and the timing of the change. Here are some key considerations:

Estate Taxes

If the life insurance policy is owned by the insured, the death benefit will be included in their gross estate and subject to estate taxes. However, transferring ownership of the policy to an irrevocable life insurance trust (ILIT) can help minimize estate taxes. When an ILIT owns the policy, the proceeds from the death benefit are not part of the insured's gross estate and are thus exempt from federal and state estate taxes.

Gift Taxes

Transferring ownership of a life insurance policy to an ILIT is considered a gift for tax purposes. If the policy has a significant cash value, it could trigger gift tax implications. To avoid gift taxes, the trustee should notify the beneficiaries of their right to withdraw contributions within a certain period (typically 30 days) using a Crummey letter. This qualifies the transfer for the annual gift tax exclusion. Any contributions exceeding the annual exclusion may use up a portion of the lifetime gift tax exemption.

Timing of Transfer

When transferring a life insurance policy to an ILIT, the timing of the transfer is crucial. There is typically a three-year lookback period for such transfers. If the insured dies within three years of transferring the policy to the trust, the death benefit will be included in their estate for estate tax purposes. Therefore, it is essential to plan ahead and make the transfer as soon as possible.

Probate

Probate is the legal process of distributing an estate to heirs, which can be time-consuming and expensive. Placing a life insurance policy in a trust can help avoid probate, ensuring that the proceeds are distributed to beneficiaries without delay or reduction due to legal fees and outstanding debts.

Tax on Investment Income

Once the death benefit has been paid, if the proceeds remain in the trust and generate investment income, that income may be subject to taxation. Therefore, it is important to consider the ongoing management and distribution of the trust funds.

State-Specific Considerations

It is important to note that tax laws vary by state. Some states have separate estate and inheritance taxes, and each state has different estate exemption and rate legislation. Consult an estate planning attorney or tax advisor familiar with your state's laws to ensure compliance and optimize tax efficiency.

Probate

Life insurance can be written into a trust so that when it pays out, it does so from the trust and not the estate. This also usually makes it exempt from any taxes (subject to approval).

An up-to-date life insurance policy does not have to go through probate. Because a beneficiary is designated within the policy, the life insurance is paid out directly to the beneficiary upon the death of the policy owner. However, if the beneficiary is a minor, the court may need to appoint a guardian, a process that would require probate even if the policy itself does not.

When a life insurance policy has to go through probate, there are administrative headaches. But there are bigger reasons to keep that policy out of the probate process. As we described in the probate steps above, debts and taxes must be paid before assets are distributed to heirs. So if a life insurance policy goes through the probate process, it will be used first to pay any remaining debts or taxes before the remainder gets distributed to any intended beneficiary.

The most important thing to remember is to keep your beneficiary designations up to date. Check them periodically, and make sure to update them after major life events such as a divorce, marriage, or death of a loved one.

Trustee responsibilities

• Understanding the Trust Document: Trustees should carefully review and understand the terms of the trust document, including any amendments that may be made over time. This document outlines the rights and responsibilities of all parties involved and guides the actions of the trustees.
• Managing Trust Assets: Trustees are responsible for managing the assets held in the trust, including life insurance policies. This includes ensuring premium payments are made on time and maintaining accurate records. Trustees must also make decisions regarding the investment of trust funds, always acting in the best interests of the beneficiaries.
• Administering Payouts: In the event of the death of the insured, trustees are responsible for submitting the necessary paperwork to initiate the payout process. They will typically provide a death certificate and any other required forms to the insurance company and ensure that the beneficiaries receive their payouts promptly.
• Communicating with Beneficiaries: Trustees should maintain open communication with the beneficiaries, keeping them informed about the status of the trust and any relevant updates. They should also be transparent about the terms of the trust and the process for accessing the benefits.
• Compliance and Taxation: Trustees are responsible for ensuring that the trust complies with all relevant laws and regulations, including tax obligations. They should seek professional advice to understand the tax implications of the trust and ensure that the beneficiaries receive their payouts in a tax-efficient manner.
• Acting in the Best Interests of the Beneficiaries: Trustees have a fiduciary duty to act in the best interests of the beneficiaries at all times. This includes making decisions that protect and preserve the assets of the trust and ensuring that the intentions of the grantor are carried out as outlined in the trust document.

It is important to note that trustees may be held legally responsible for any breaches of their duties, so it is crucial to fully understand and adhere to the responsibilities of the role. Seeking professional advice from legal and financial experts can help ensure that trustees fulfil their duties effectively and in compliance with all relevant laws.

Estate planning

Benefits of Placing Life Insurance in a Trust:

• Tax advantages: One of the primary motivations for placing life insurance in a trust is to minimise tax liabilities for your beneficiaries. By doing so, the proceeds of the life insurance policy are typically excluded from your taxable estate, which can result in significant tax savings, especially if your estate exceeds the state's estate tax exemption threshold.
• Control over distribution: A trust allows you to maintain control over how and when the life insurance payout is distributed to your beneficiaries. This is particularly advantageous if you want to provide for minor children or ensure that the funds are used for specific purposes, such as education or medical expenses.
• Avoid probate: Placing life insurance in a trust helps your beneficiaries avoid the probate process, which can be lengthy and costly. The funds can be distributed more quickly and efficiently, ensuring that your loved ones receive the financial support they need in a timely manner.
• Protection from creditors: In most states, life insurance policies held in a trust are protected from creditors, providing an additional layer of financial security for your beneficiaries.

Limitations and Complexities:

• Loss of control: Once you transfer ownership of your life insurance policy to a trust, you lose the ability to make changes to the policy or its beneficiaries. This irreversible decision requires careful consideration, especially if your circumstances or wishes may change over time.
• Legal and tax implications: Establishing a trust can be complex and carries significant legal and tax implications. It is crucial to seek professional legal and financial advice to ensure you fully understand the consequences and that the trust is structured appropriately for your specific situation.
• Cost of setup: Setting up a trust can be expensive, and you may need to consult multiple professionals, including estate planning attorneys and financial advisors. Additionally, there may be ongoing costs associated with trust administration and management.
• Time and effort: Establishing and maintaining a trust requires a considerable time investment. You will need to work closely with your trustees to ensure that premiums are paid annually and that all necessary documentation and notifications are provided in a timely manner.

In conclusion, placing your life insurance policy in a trust can be a valuable component of your estate plan, particularly if you have a large estate, want to provide for minor children, or wish to minimise tax liabilities for your beneficiaries. However, it is important to carefully weigh the benefits against the limitations and complexities involved. Consulting with qualified professionals can help you make an informed decision that aligns with your unique circumstances and goals.

Frequently asked questions