Life Insurance And Trusts: What's The Deal?

Life insurance is a financial product that offers peace of mind to those who worry about what will happen to their dependents when they are gone. However, the intricacies of the product can be complex, and there are many factors to consider when it comes to managing your finances and estate. One such consideration is whether to put your life insurance in a trust. This essentially means transferring the legal ownership of your life insurance to trustees, giving them control over the policy and its payout. This article will explore the pros and cons of putting life insurance in a trust and outline the steps to doing so.

Pros of listing a trust as your life insurance beneficiary

Yes, you can put life insurance in a trust. Here are the pros of listing a trust as your life insurance beneficiary:

Probate is avoided

Probate is a lengthy and costly procedure that entails proving your estate and then distributing it to your heirs. By naming a trust as your life insurance beneficiary, you can avoid probate, which means your family members won't have to deal with it in the event of a tragedy.

Control over cash flow

A trust allows you to control how much money is distributed to your children and when. For example, you can adjust the trust to cover the costs of caring for your children while they are minors, and then stipulate that they receive the remaining funds when they turn 18. This flexibility is crucial for young and growing families, as it enables you to adjust the trust as your children get older and your financial needs and wishes change.

Protection of assets

A revocable trust protects your assets as you age. You can take distributions from the trust until you pass away, at which point they are transferred to the trust's beneficiaries.

Tax advantages

If your estate exceeds your state's estate tax exemption threshold, placing your life insurance policy in an irrevocable life insurance trust can help minimise taxes. The proceeds of a death benefit payout will not be included as part of your taxable estate if a trust owns the policy.

Cons of listing a trust as your life insurance beneficiary

While listing a trust as your life insurance beneficiary can be beneficial, there are some drawbacks to consider. Here are some cons of listing a trust as your life insurance beneficiary:

High Setup Costs

The cost of setting up a revocable living trust can be significant, including legal fees and expenses related to transferring ownership of assets. This process can also be time-consuming, requiring additional estate planning considerations such as a will.

Tax Implications

Trusts are not considered individuals for tax purposes, so life insurance proceeds paid to trusts may be subject to estate taxes. This is in contrast to naming a spouse as a beneficiary, which is generally tax-free. Trusts may also not qualify for inheritance tax exemptions provided by some states for insurance payable to a named beneficiary, resulting in a higher tax burden.

Unfavorable Conditions

When a trust is named as the beneficiary of a life insurance policy, it may be subject to certain conditions, such as required minimum distribution payouts based on the life expectancy of the oldest beneficiary. This can reduce the flexibility of distributions and impact the overall amount available to beneficiaries.

Lack of Control

Once a trust is set up and beneficiaries are named, it is challenging to make changes. Irrevocable trusts, in particular, cannot be modified, even in the event of divorce or a change in beneficiary preference. This lack of flexibility can be a significant disadvantage if circumstances change over time.

Complexity

Listing a trust as a beneficiary can add complexity to the distribution of life insurance proceeds. In some cases, it may be more straightforward to name specific individuals as beneficiaries, especially if they are a spouse or dependent children, as this simplifies the tax and legal implications.

In conclusion, while listing a trust as your life insurance beneficiary can offer certain advantages, it is important to carefully consider the potential drawbacks. The complexity, costs, and tax implications associated with trusts may outweigh the benefits for some individuals, especially those without high net worth or complex financial situations.

How does life insurance in trust work?

Putting your life insurance in trust allows you to decide who you want the money to go to if you die. These people are called the beneficiaries and can be family members or friends. The life insurance policy is then looked after by trustees, who could be family members, friends, or a solicitor, until it’s paid out to a beneficiary. Trustees meet to discuss the policy and must all agree before any action is taken.

There are several advantages to putting life insurance in trust. Firstly, you specify exactly where you want your money to go and when. For example, you can appoint a trustee to look after the money if a child is under the age of 18. Secondly, it helps lower inheritance tax. When you die, the money included in your life insurance policy is taxed at 40% if it goes over the allowance (currently £325,000 in the UK). The money from your trust is paid directly to your beneficiaries and not counted as part of your estate, which can help lower the value of your estate for tax purposes. Thirdly, probate doesn't need to happen on the money from your policy. Probate is a legal process that confirms an executor's authority to deal with your assets and possessions, which can be lengthy, especially if there’s no will in place. Finally, payouts can be faster as they don't need to go through probate.

There are five different types of trust policies: absolute trust, discretionary trust, flexible trust, split trust, and survivor's discretionary trust. Absolute trust involves naming the beneficiaries, which cannot be changed in the future. Discretionary trust allows you to write a letter of wishes stating where you want your money to go when you die, with trustees having a high level of discretion about paying your beneficiaries. Flexible trust is similar, with there being a default beneficiary and the option of additional discretionary beneficiaries. Split trust allows you to use the critical illness element of a policy while keeping the life insurance within the trust. Finally, survivor's discretionary trust allows couples with a joint life insurance policy to put it in trust, with the surviving partner receiving money straight from the trust before other beneficiaries.

The main disadvantage of putting life insurance in trust is that it can be difficult to make changes once it's set up. When your life insurance policy is written in trust, it is technically owned by the trustees, meaning it may be not straightforward or even possible to make changes.

What are the different types of trusts for life insurance?

Trusts are a great way to secure your family's future. They involve a trustee who manages assets for your beneficiaries. There are two common types of life insurance trusts: irrevocable and revocable.

Irrevocable Life Insurance Trusts (ILIT)

An irrevocable life insurance trust is a type of trust that holds and manages life insurance policies. It is "irrevocable" because it can't be changed or cancelled after it's been set up. This means that you won't be able to change or revoke the trust once it's in place. An ILIT provides benefits such as avoiding estate taxes and protecting assets from creditors. However, it also comes with drawbacks such as high legal fees and a lack of control over how the funds are used and distributed.

Revocable Life Insurance Trusts (RLIT)

A revocable life insurance trust, also known as a living trust, can be changed or cancelled by the grantor at any time. With an RLIT, you retain control over the life insurance policy and can change the trust's terms as needed. The trust becomes irrevocable after your death or if you become incapacitated. RLITs do not offer the same tax advantages as ILITs and may be subject to estate taxes upon the death of the grantor.

Other Types of Trusts

In addition to ILITs and RLITs, there are also funded and unfunded insurance trusts. Funded insurance trusts own one or more insurance contracts and income-producing assets, while unfunded insurance trusts are funded by annual gifts from the grantor.

What are the pros and cons of setting up a life insurance in trust?

Setting up life insurance in trust can give you more control over your life insurance payout and help your beneficiaries avoid paying inheritance tax. However, there are several pros and cons to consider before making this decision.

Pros

No inheritance tax

Life insurance payouts are usually subject to inheritance tax, which can be as high as 40%. By setting up a trust, you can ensure that your beneficiaries do not have to pay this tax.

Quicker payouts

Without a trust, your beneficiaries would have to go through the probate process, which can take many months. With a trust in place, they can receive the money in just a few weeks.

Free to set up

Many insurance providers will help you set up a trust for free, although it is worth checking this beforehand.

Control over how the money is distributed

You can choose your beneficiaries and how they receive the money. For example, you can specify that your children only receive the payout once they reach a certain age.

Cons

Loss of control over your life insurance

Once you set up a trust, you no longer have control over your life insurance as you have transferred legal ownership to a trustee. This decision is irreversible.

Legal and tax implications

There are complex legal and tax implications to consider when setting up a trust. It is important to seek professional advice to understand the potential consequences.

Risk of invalidating insurance

In rare circumstances, amending a trust may invalidate your life insurance policy.

Seven-year rule

If you change your beneficiary and pass away within seven years, or if your new beneficiary is not a spouse or civil partner, inheritance tax may still be due.

Frequently asked questions