Life Insurance: A Generational Inheritance?

Life insurance is a valuable tool for inheritance planning and can be used to transfer wealth to the next generation. It offers several benefits, including tax advantages, flexibility in distribution, and the potential for an attractive rate of return. The two main types of life insurance are term life and permanent life. Term life insurance is less expensive but only covers a specific period, while permanent life insurance can last an entire lifetime and ensure an inheritance for the next generation. When using life insurance for inheritance planning, it is important to regularly review beneficiaries and policy details, engage in estate planning, and seek professional advice to optimize tax benefits and ensure fair distribution among beneficiaries.

Naming a trust as a beneficiary

Benefits of Naming a Trust as Beneficiary

One of the primary benefits of naming a trust as the beneficiary of your life insurance policy is that it gives you control over how the proceeds are distributed. By creating a trust, you can specify how the life insurance payout should be allocated to your beneficiaries. This is especially valuable if you have concerns about the financial responsibility of certain beneficiaries. A trust also allows you to control the cash flow distributed to your children, ensuring the funds are used for their care as you intended.

Naming a trust as the beneficiary can help you avoid probate, a lengthy and costly legal process where your estate is proven and distributed to your heirs. With a trust in place, the distribution of the life insurance proceeds remains private and is not subject to public scrutiny.

Additionally, a trust can provide protection for the life insurance proceeds, shielding them from creditors, lawsuits, divorces, or other financial setbacks that your beneficiaries may face in the future.

Types of Trusts

When naming a trust as a beneficiary, you can choose between an irrevocable trust and a revocable trust. An irrevocable trust offers tax benefits but cannot be modified once established. On the other hand, a revocable trust provides flexibility as it can be amended at any point during your lifetime. It also protects assets as you age and allows you to take distributions from the trust until your passing.

Considerations and Caveats

While naming a trust as the beneficiary offers several advantages, there are some important factors to keep in mind. Creating a trust and designating it as the beneficiary is a complex legal process that requires careful consideration and professional guidance. Consult with an experienced estate planning attorney and financial advisor to ensure your trust aligns with your goals and meets all legal requirements.

Naming a trust as the beneficiary adds an extra layer of complexity to the distribution process, as the trustee will be responsible for managing and distributing the proceeds according to the trust's terms. Choose a knowledgeable and trustworthy trustee.

Different types of trusts have varying tax implications, so it's crucial to understand how naming a trust as a beneficiary might affect the tax treatment of the life insurance proceeds and your overall estate plan.

Naming your trust as the beneficiary of your life insurance policy can provide probate avoidance, control, protection, and privacy, while helping streamline the distribution of assets to your loved ones. However, it's important to seek professional advice to navigate the legal and tax complexities involved. With careful planning and guidance, you can make a decision that aligns with your long-term financial goals and provides lasting security for your beneficiaries.

Life insurance and tax

Life insurance can be an effective way to pass on money to heirs without them having to pay taxes on it. However, there are certain scenarios in which beneficiaries may have to pay taxes on the proceeds.

Tax-Free Scenarios

In general, life insurance proceeds are not taxable, meaning beneficiaries do not have to pay income tax on the proceeds. The death benefit is typically paid directly to the beneficiaries and is tax-free. This is the case for term, whole, and universal life insurance policies.

Taxable Scenarios

There are some cases, however, where the death benefit can be taxed. These include:

• Payout structure: If the payout is set up to be paid in multiple instalments, these payments can be subject to taxes. For example, an annuity that is paid regularly over the life of the beneficiary includes proceeds and interest, which can be taxed.
• Withdrawal or loan against the policy: Some life insurance policies, such as whole life insurance, allow the policyholder to withdraw or take out a loan against the policy. If the amount withdrawn or loaned exceeds the total amount of premiums paid, the excess may be taxable.
• Surrendering the policy: If a policyholder surrenders their life insurance policy, the amount they get back is usually considered a tax-free return of their principal. However, any amount received over the policy's cash basis will be taxed as regular income.
• Employer-paid group life plan: In some cases, an employer-paid plan that pays out more than $50,000 may be taxable, according to the Internal Revenue Service (IRS).
• Estate tax threshold: If life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, this threshold was $12.92 million.

It is important to note that even if the payout is tax-free, beneficiaries may still have to pay taxes on any interest earned on the principal amount. This typically occurs when the beneficiary receives the payout in instalments, as the principal amount can generate interest while being held by the insurer.

Probate

Life insurance proceeds typically do not go through probate. Instead, they are paid directly to the named beneficiaries of the policy. This means that the funds do not have to go through probate or pay off any outstanding debts before reaching the beneficiaries. However, if the insurance policy is payable to the estate or if the named beneficiary dies before the policyholder, the life insurance funds will be estate assets and will go through probate.

The process for receiving life insurance proceeds depends on whether one is a named beneficiary or will inherit through the estate. If one is a named beneficiary, they will need to provide proof of the insured person's death and proof that they are the intended recipient of the benefits. This typically includes submitting a certified copy of the death certificate and a copy of the policy. If the inheritance is paid through a trust, the trustee is responsible for disbursing the funds according to the trust documents.

If there is a dispute over who should receive the proceeds from a life insurance policy, it may be necessary to go through probate court for resolution. This process can take several months or even years, depending on its complexity. The probate court will resolve any disagreements and ensure that all parties receive their fair share of the inheritance.

It is important to note that while life insurance proceeds are typically not taxable, beneficiaries may have to pay tax on any interest earned on the principal amount. This typically occurs when the beneficiary receives the payout in installments, and the interest is earned while the principal amount is being held by the insurer.

Irrevocable life insurance trusts

An irrevocable life insurance trust (ILIT) is a legal arrangement that allows individuals to minimise their current tax burden and the impact of taxes on their estate. It is particularly useful for affluent families with a sizable estate or those with loved ones who have special needs and require ongoing care.

ILITs are structured between three legal parties: the grantor (who creates and funds the trust), the trustee (who manages the trust and pays insurance premiums), and the beneficiary/beneficiaries (who will receive the assets upon the grantor's death).

Benefits of ILITs

ILITs offer several advantages, including:

• Tax benefits: They can help lower your current tax burden by removing taxable assets from your portfolio. Additionally, they can help avoid estate taxes on life insurance benefits, ensuring that more of the proceeds go to your beneficiaries.
• Asset protection: ILITs can protect your assets from creditors. While each state has its own rules regarding how much of the insurance policy's cash value or death benefit can be protected, any excess value above those limits is generally shielded from the creditors of both the grantor and the beneficiary.
• Government benefit protection: For beneficiaries with special needs, ILITs can ensure that inherited assets don't interfere with their eligibility for government benefits such as Social Security Disability Income or Medicaid. The trustee can manage distributions to maintain eligibility.
• Legacy benefits: Transferring ownership of a life insurance policy to an ILIT can make it easier for your beneficiaries to qualify for Medicaid and other government assistance programs.

Downsides of ILITs

The main downside of ILITs is that they are irrevocable. This means that, unlike a revocable trust, you cannot easily modify or terminate the trust once it is established. You relinquish control over the assets, and any changes would require legal action or the consent of the beneficiaries.

How ILITs Work

By setting up an ILIT, you transfer taxable assets from your estate to a separate legal entity (the trust). The trustee uses these assets to purchase a life insurance policy in your name and pays the premiums to keep the policy in force. When you pass away, the policy's death benefit is paid directly to the trust, which then distributes the proceeds to the named beneficiaries.

ILITs and Estate Planning

ILITs have long been a staple of estate planning, helping individuals, families, and business owners achieve various goals. They can be particularly useful for covering estate taxes and other expenses after your death, preventing the need to sell high-value assets. Additionally, ILITs can provide protection beyond taxes, such as shielding assets from divorce, creditors, and legal action.

Life insurance as an asset

Life insurance is a financial asset that can be used to leave an inheritance for your loved ones after you pass away. While the death benefit of a life insurance policy is not considered an asset, some policies, known as permanent life insurance policies, have a cash value that is considered an asset. These policies are designed to last for the entirety of the policyholder's life and include whole life insurance and universal life insurance.

Permanent life insurance policies offer an additional living benefit called cash value, which can be accessed by the policyholder during their lifetime. This cash value grows tax-deferred and can be accessed tax-free if the policy is designed properly. The policyholder can borrow against the cash value, use it as collateral for a loan, or withdraw funds. The cash value can also be used to pay off debts, provide financial security for loved ones, or cover final expenses, including burial costs, estate taxes, and other inheritance taxes.

One of the main benefits of using life insurance as an asset is that the death benefit is typically tax-free. This means that beneficiaries do not have to pay income tax on the proceeds. However, they may have to pay tax on any interest earned on the principal amount if they receive the payout in installments. Additionally, the payout goes directly to the beneficiaries, bypassing probate and ensuring that they receive the funds regardless of how the estate is handled.

Another advantage of life insurance as an asset is the potential for an attractive rate of return. Upon the insured's death, the proceeds paid to beneficiaries are not subject to income tax. When taking into account the premiums paid relative to the tax-free proceeds received at death, the internal rate of return (IRR) can be significant, especially if the insured dies prior to reaching life expectancy.

When considering life insurance as an asset, it is important to note that not all policies are created equal. Term life insurance policies, which are generally less expensive and valid for a set number of years, do not offer the ability to grow cash value. Therefore, when shopping for a policy, individuals should consider permanent life insurance policies that can serve as an asset and help achieve their financial goals.

Frequently asked questions