Putting Life Insurance In Trust: What You Need To Know

Putting your life insurance in trust gives you more control over your life insurance payout and helps your beneficiaries legally avoid paying inheritance tax. It can also offer a quicker payout as your beneficiaries won't have to go through probate, which can take months. However, as you're handing over the legal ownership of your life insurance to a trustee, you won't have any control over it. This decision is also irreversible.

There are two common types of life insurance trusts: irrevocable and revocable. An irrevocable life insurance trust (ILIT) is locked in stone and can't be changed or cancelled, whereas a revocable life insurance trust (RLIT) gives you more flexibility and can be altered by the grantor at any time.

Irrevocable vs Revocable Trusts

A trust is a legal entity that a person creates to hold their assets. Trusts are versatile financial tools used for estate planning, asset protection, and charitable giving. There are two main types of trusts: revocable and irrevocable.

Revocable Trusts

A revocable trust, also known as a living trust, can be altered, modified, or revoked by the grantor (the person who created the trust) during their lifetime. The grantor can retain control over the assets in the trust and can add, remove, or change beneficiaries whenever they want. Revocable trusts are useful for distributing assets to beneficiaries without going through probate court, which can be costly and time-consuming for the family. Additionally, since probate is a public record, a revocable trust can help keep the family's privacy intact. However, a revocable trust does not shield assets from creditors or lawsuits.

Irrevocable Trusts

On the other hand, an irrevocable trust, once established, generally cannot be altered, modified, or revoked by the grantor without the consent of each beneficiary. Once assets are transferred to an irrevocable trust, the grantor gives up direct control over those assets to a separate trustee, and the terms and conditions become legally binding. While this may seem like a disadvantage, irrevocable trusts offer several benefits. Firstly, since the grantor no longer owns the assets, they are not included in the grantor's taxable estate, which can result in significant tax savings for the family. Secondly, the trust can shield those assets from creditors or lawsuits, which is particularly important for individuals in professions with a higher risk of lawsuits, such as lawyers and doctors.

How to Put Life Insurance in a Trust

If your estate exceeds your state's estate tax exemption threshold, it may be wise to place your life insurance policy in an irrevocable life insurance trust (ILIT). By doing so, the proceeds of the death benefit payout will not be included as part of your taxable estate. However, for most individuals without a high net worth, naming beneficiaries individually on life insurance policies is often a more straightforward option.

Tax benefits

One of the primary benefits of putting your life insurance in trust is that it helps you avoid paying inheritance tax. When you die, your estate is valued, and if its value exceeds a certain threshold, it is taxed at a rate of 40%. In the UK, the threshold is £325,000. In the US, the federal estate tax exemption is $12.06 million for 2022 and $12.92 million for 2023, but some states have much lower exemptions. For example, Oregon's estate tax exemption is only $1 million.

If you have a conventional life insurance policy, its value will be included in the calculation of your estate. However, if your life insurance is placed in a trust, the proceeds will be sent directly to your beneficiaries and will not be counted as part of your estate, thus avoiding the inheritance tax threshold. This could help lower your estate's value and limit the impact of inheritance tax.

Additionally, by putting your life insurance in trust, you can also avoid probate, which is the legal process of confirming an executor's authority to deal with your assets and possessions after your death. Probate can be a lengthy process, especially if there is no will in place. With a trust in place, probate can be bypassed, and the only requirement for the policy to be paid out is a death certificate. This means that payouts can be faster and your beneficiaries can receive the money more quickly.

It is important to note that the decision to put your life insurance in trust is usually irrevocable and cannot be changed once it has been made. Therefore, it is essential to carefully consider the advantages and disadvantages before proceeding.

Estate planning benefits

Estate planning is a complex process that requires careful consideration of various factors, including your goals, family dynamics, and tax implications. Putting your life insurance in trust can offer several benefits that may align with your estate planning objectives:

Management and Control of Assets:

By placing your life insurance in a trust, you gain more control over the management and distribution of the insurance funds. The trust allows you to outline your wishes for how the income and principal should be distributed. This ensures that the proceeds are used according to your intentions and provides peace of mind that your beneficiaries will be taken care of in the way you intended.

Protection from Creditors:

In most states, life insurance proceeds are generally protected from creditors under state law. However, if your beneficiaries have creditors, putting your life insurance in trust adds an extra layer of protection. The trust can shield distributions from creditors, ensuring that the funds are used solely for the benefit of your beneficiaries.

Reduced Federal Estate Tax:

One of the significant benefits of placing your life insurance in an irrevocable life insurance trust (ILIT) is the potential reduction in federal estate tax liability. The ILIT is considered a separate taxpayer, so the value of the trust is not included in your gross estate for tax purposes. This can result in significant tax savings for your estate and beneficiaries.

Maintaining Governmental Benefits:

If you have a beneficiary with special needs who is receiving governmental assistance, a life insurance trust can help maintain their benefits. The trust can be structured with special needs provisions to protect the interests of the beneficiary, ensuring they continue to receive the support they need without disrupting their eligibility for assistance programs.

Avoiding Guardianship for Minors:

In certain states, if a minor inherits a substantial amount of money, a guardianship may need to be established. By placing your life insurance in trust, you can avoid this court intervention. The trust can act as the beneficiary, allowing the proceeds to be administered for the benefit of the minor without the need for a legal guardian.

Liquidity:

Life insurance policies provide immediate liquidity to your beneficiaries upon your passing. This is especially beneficial if your estate includes illiquid assets, such as property or a business, which may take time to convert into cash. The insurance proceeds can offer your loved ones financial support and stability during the estate settlement process.

Choosing beneficiaries

Default Beneficiaries

If you do not specifically choose beneficiaries for your life insurance policy, most policies will have default beneficiaries. Typically, the default beneficiary is the insured's estate, which means the policy will go through probate and be distributed to the insured's heirs-at-law. While it may seem unusual not to name a beneficiary, it is not uncommon.

Naming Minor Children as Beneficiaries

It is important to note that you should never name a minor as a direct beneficiary of any asset, including life insurance policies. If you name a minor child as a beneficiary, they will not have access to the funds until they turn 18, and the money will be supervised by the probate court until they reach legal age. Once they turn 18, they will have full control over the funds, which may be concerning if they are not yet financially responsible.

Spouse as Primary Beneficiary

In most cases, naming your spouse as the primary beneficiary is the most straightforward and beneficial choice. Assets can be transferred to a spouse tax-free, regardless of the amount, as long as the spouse is a US citizen. This option simplifies the process and ensures your spouse can maintain their current lifestyle after your passing.

Children as Beneficiaries

If you want your life insurance benefits to go directly towards the care and future inheritance of your minor children, you may consider naming a trust as the beneficiary. This option provides control over how the funds are used and distributed over time. It also allows you to bypass the probate process, which can be costly and time-consuming, ensuring your children's caregiver receives the money without delay.

Revocable vs. Irrevocable Trusts

When deciding to name a trust as a beneficiary, you can choose between a revocable trust and an irrevocable trust. A revocable trust offers flexibility, as it can be modified by the owner at any time. This type of trust is ideal for families who want to protect their life insurance benefits for their children's care or future inheritance. On the other hand, an irrevocable trust cannot be changed once it is set up, even in the event of a divorce or change in preferences.

Tax Implications

It is important to consider the tax implications of your beneficiary choices. While distributions to a spouse are typically tax-free, naming other individuals as beneficiaries may result in estate tax liabilities. By placing your life insurance policy in an irrevocable trust, you can avoid having the proceeds included in your taxable estate. However, trusts may be subject to estate taxes, as they are not considered individuals. Consult with a tax advisor to understand the tax consequences for your specific situation.

In conclusion, choosing beneficiaries for your life insurance policy requires careful consideration. It is essential to seek professional guidance from an experienced estate planning attorney and financial advisor to ensure your choices align with your goals and meet all legal and tax requirements.

Funding options

There are two common types of life insurance trusts: irrevocable and revocable. The type of trust you choose will depend on factors such as your financial situation and estate planning goals.

Irrevocable Life Insurance Trusts (ILIT)

Irrevocable trusts cannot be changed, altered, or revoked once they are set up. They offer the benefit of shielding assets from creditors and avoiding estate taxes. However, you will need to survive the transfer by three years or your estate will be taxed. This type of trust is ideal for those wanting to reduce estate tax or protect assets from creditors.

Revocable Life Insurance Trusts (RLIT)

Revocable trusts, also known as living trusts, can be changed, altered, or revoked by the grantor at any time. They do not offer the same tax advantages as irrevocable trusts and are subject to estate taxes upon the grantor's death. This type of trust is ideal for growing families whose needs may change in the future.

In addition to choosing the type of trust, you will also need to select the type of life insurance policy to fund it. Permanent life insurance policies, such as whole life or universal life insurance, are typically used for life insurance trusts as they provide a guaranteed death benefit. However, term life insurance can also be used and is a more affordable option.

When funding a trust, you can also consider alternative assets such as cash, stock investments, business interests, real estate, or personal property. These options may be more suitable if you don't want to purchase or maintain a life insurance policy. However, relying solely on cash may not provide a sufficient financial cushion for your beneficiaries.

Frequently asked questions