Putting Life Insurance In A Trust: A Simple Guide

A life insurance trust is a legal agreement that allows a third party to manage the death benefit from a life insurance policy. It ensures that the benefit is distributed to beneficiaries according to the insured person's wishes. There are two types of life insurance trusts: irrevocable and revocable. An irrevocable life insurance trust (ILIT) cannot be changed or cancelled once created, and is a separate taxpayer, meaning proceeds from the policy are not subject to federal estate tax. A revocable life insurance trust can be modified or cancelled, and is useful for parents who want to control how their children receive their inheritance.

Irrevocable life insurance trusts (ILITs)

ILITs are set up 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). The grantor removes taxable assets from their estate and transfers them to the trust, a separate legal entity. The trustee then uses these assets to purchase a life insurance policy in the grantor's name, which remains in force as the trustee continues to pay the premiums. When the grantor passes away, the death benefit is paid directly to the trust, which then distributes the proceeds to the named beneficiaries.

ILITs are a powerful tool for tax planning and wealth transfer, allowing individuals to reduce their current tax burden by removing taxable assets from their portfolio. They also provide a tax-efficient way to transfer wealth to beneficiaries outside of the taxable estate. ILITs can also protect legacy assets from potential creditors, as each state has rules regarding how much of an insurance policy's value or benefit can be protected from creditors.

Another benefit of ILITs is that they can help set aside assets for family members with special needs without interfering with their eligibility for government benefits. The trustee can carefully control how the distributions from the trust are used, ensuring that the beneficiary's eligibility for benefits such as Social Security Disability Income or Medicaid is maintained.

It is important to note that ILITs are irrevocable, meaning they cannot be easily modified or terminated once established. This is the main downside of ILITs, as the grantor relinquishes control over the assets placed in the trust. Therefore, it is crucial to work with experts in the field, such as a tax attorney, trust officer, or financial professional, to ensure that an ILIT is set up and funded appropriately.

Revocable life insurance trusts

A revocable life insurance trust (RLIT) is a type of trust that you may want to consider if you're seeking more control over your life insurance policies as part of your estate planning strategy. It allows the grantor (the person creating the trust) to maintain control and make changes to the trust at any time, including adjustments to the life insurance policies it holds. This flexibility can be beneficial as your situation evolves, especially if you have concerns about leaving a large sum of money to a young or special-needs beneficiary.

With an RLIT, you can specify how and when your beneficiaries receive payments. For example, you can stipulate that funds are distributed in instalments over an extended period, ensuring your beneficiaries receive financial support at important milestones or life events. This feature can be particularly valuable if you want to provide for a special-needs child who will require long-term care after you're gone.

Another advantage of an RLIT is that it can help preserve your child's eligibility for essential government benefits, such as Medicaid. Since the trust owns the assets, it can shield them from means-testing, ensuring your child continues to receive the support they need.

When it comes to funding an RLIT, you have the option to either purchase a new life insurance policy and name the trust as the owner and beneficiary or transfer an existing policy into the trust. Permanent life insurance policies, such as whole life or universal life, are often preferred as they provide a guaranteed death benefit and can accumulate cash value over time.

It's important to note that life insurance trusts, including revocable trusts, can have significant tax implications during the grantor's lifetime and after their death. Therefore, it's essential to consult with an experienced estate planning attorney or financial professional to understand the tax consequences and ensure the trust is structured to mitigate potential tax liabilities.

Estate planning

A trust is a legal vehicle that allows a third party (the trustee) to hold and manage assets for the benefit of one or more beneficiaries. Trusts can be a critical component in estate planning, helping to protect your assets and ensure the financial future of your loved ones. They can be used in combination with wills and guardianship documents to form a comprehensive estate plan.

A life insurance trust is a type of trust designed to be the owner or beneficiary of your life insurance policy. It ensures that the death benefit from your policy is distributed to your beneficiaries according to your wishes and may also provide tax advantages. There are two main types of life insurance trusts: irrevocable and revocable.

An irrevocable life insurance trust (ILIT) cannot be changed or cancelled once created, meaning the assets placed within it are permanently out of your control. This can be beneficial for estate tax planning, as the assets in the trust are not considered part of your taxable estate. ILITs are commonly used by high-net-worth individuals whose estates exceed the federal estate tax threshold.

On the other hand, a revocable life insurance trust offers more flexibility and control, as you can amend or revoke the trust at any time. While it doesn't provide the same tax advantages as an ILIT, it is often chosen for its management benefits. Revocable trusts are useful for parents who want to structure benefit payments to their children, ensuring they don't spend their entire inheritance at once.

To set up a life insurance trust, you will need to work with an estate planning attorney to create the trust document. You will need to decide who will act as the trustee and determine the circumstances under which your beneficiaries will have access to the insurance proceeds. Once the trust document is drafted and signed, you will need to transfer ownership of your life insurance policy to the trust.

It's important to note that establishing a life insurance trust can be costly and time-consuming, and it may create additional tax and legal complexities. As such, it is generally recommended only for individuals with substantial wealth or specific estate planning objectives, such as parents with young or special-needs children.

Tax implications

Life insurance trusts can have significant tax implications, both during the grantor’s lifetime and after their death. During the grantor’s lifetime, the trust may be subject to income tax on the earnings of the life insurance policy. Additionally, if the grantor transfers assets to the trust, those transfers may be subject to gift tax.

After the grantor’s death, the death benefit of the life insurance policy may be subject to estate tax. However, if the trust is properly structured, the death benefit can be excluded from the grantor’s estate for estate tax purposes. This exclusion can help mitigate estate tax liabilities, ensuring that the trust assets pass to the beneficiaries with reduced tax burdens.

In the UK, if your total estate, including your life insurance, is worth more than £325,000, there may be a 40% inheritance tax bill to pay on the part over and above that amount. Putting your life insurance in trust means it’s legally owned by your trustees and isn’t part of your estate. This means it doesn’t count towards that £325,000, and that means your loved ones get the full pay-out.

Given the complexity of tax laws and regulations surrounding life insurance trusts, it’s essential to work with an estate planning attorney. They can help you understand the tax implications and ensure that the trust is structured in a way that helps mitigate tax liabilities. An experienced attorney can navigate the intricate tax landscape, ensuring compliance with all applicable laws and helping you achieve your estate planning goals.

Benefits of owning life insurance in a trust

There are several benefits to owning life insurance in a trust. Here are some key advantages:

Management and Control of Assets

A life insurance trust provides for the management and distribution of life insurance funds. The income and principal of the trust can be distributed according to your wishes. Without a trust, you will not have control over how your beneficiaries spend the funds. A trust helps ensure that the proceeds last for a reasonable time and are used properly.

Protection from Creditors

Proceeds from life insurance are typically protected under state law, shielding them from creditors. A trust offers an additional layer of protection by allowing you to safeguard your beneficiaries from their creditors or any unforeseen divorce.

Reduce Federal Estate Tax

An irrevocable life insurance trust (ILIT) can be used to reduce estate tax liability. The death benefit is excluded from the insured's gross estate, avoiding state and federal estate taxation. This can lead to significant tax savings when passing on assets to heirs.

Maintain or Qualify for Government Benefits

A life insurance trust can be crucial if you have a beneficiary who is disabled and receiving government assistance, such as Medicaid. The trust can be set up to protect the interests of the beneficiary and ensure they continue to receive their government benefits.

Avoid Guardianship for Minors

In certain states, if a minor receives a large sum of money, a guardianship must be established, which can be costly and court-intrusive. With a life insurance trust, the trust becomes the beneficiary, and proceeds can be administered for the benefit of the minor without court intervention.

Liquidity

Life insurance trusts provide liquidity for heirs, allowing them to access funds immediately, which can be especially important if there are large assets, such as property or a business, that may take time to sell or liquidate.

Frequently asked questions