Borrowing Against Family Trust Life Insurance: What You Need To Know

Borrowing against a life insurance policy can be a quick way to get cash, but it also has its risks. To borrow against life insurance, you need a policy with cash value, which is usually a feature of permanent life insurance policies. Term life insurance, typically provided by employers, does not facilitate borrowing. If you have the right policy with enough cash value, you can request a loan without a credit check or employer and income verification. However, if you pass away before repaying the loan, the balance and interest could be subtracted from the death benefit, reducing the amount received by your beneficiaries.

Borrowing against a life insurance policy

Firstly, it is essential to know that you can only borrow against a permanent life insurance policy, such as a whole life insurance or universal life insurance policy. These policies are more expensive than term life insurance but have no predetermined expiration date. They also have a cash value component, which is a savings-like account that grows tax-free over time. This cash value can be used as collateral to secure a loan from your insurance company. The minimum amount required to borrow varies by insurer, and it typically takes several years for the policy to accrue enough value to borrow against.

There are several benefits to borrowing against a life insurance policy. It offers quick access to cash without any additional requirements, such as a credit check, employment verification, or minimum income requirements. Additionally, there is no formal approval process, as the value of the plan is technically yours. These loans also do not affect your credit score and have flexible repayment schedules. Furthermore, life insurance loans are generally not recognised by the IRS as income, so you may not have to pay taxes on them.

However, there are also some drawbacks and risks to consider. If you are unable to make timely loan payments, you may lose your life insurance plan. If the loan is not repaid before the policyholder's death, the beneficiary will receive a reduced death benefit, as the insurer will deduct the amount owed from the total benefit. Additionally, if the policy lapses or the loan is not repaid, you may owe taxes on the borrowed amount. It is crucial to continue making regular premium payments to avoid a lapse in coverage.

Before borrowing against a life insurance policy, it is important to weigh the pros and cons and consult with a financial advisor to understand the tax implications and potential risks involved.

Pros and cons of a life insurance loan

Borrowing against a life insurance policy can be a quick and easy way to obtain money, but it's not without its risks. Here are some pros and cons to consider:

Pros

• Quick access to cash: There is no approval process, credit check, or income verification, so you can get money when you need it.
• No repayment schedule: You can pay back the loan whenever you want or let it sit without making payments.
• Low interest rates: Interest rates for life insurance loans typically range from 5% to 8%, which is lower than the average rate for personal loans and credit cards.
• No restrictions on spending: There are no restrictions on how you can spend the money.
• Tax-free: Life insurance loans are generally tax-free, and the cash value continues to grow after you borrow against it.

Cons

• Reduced death benefit: If you don't repay the loan before you die, the loan amount plus interest will be deducted from the death benefit that goes to your beneficiaries.
• Interest owed: You will owe interest on the loan, which will continue to accrue until the loan is repaid.
• Risk of losing coverage: If the loan balance exceeds the policy's cash value, your policy could lapse, and you could lose your insurance coverage.
• Tax implications: If you don't repay the loan or your policy lapses, you may owe taxes on the amount borrowed.

Irrevocable vs revocable life insurance trusts

Trusts are a critical component in estate planning, helping to protect your assets and the financial future of your family. Trusts can be set up in a number of ways, but they often include life insurance.

There are two basic types of life insurance trusts: irrevocable and revocable. The type of trust you choose will depend on your financial situation, your estate planning goals, and how much control you wish to maintain over your assets.

Irrevocable Life Insurance Trusts (ILIT)

Irrevocable Life Insurance Trusts are permanent and cannot be altered, modified, or revoked once they have been established. While this limits your control over your assets, it can be beneficial for those with substantial wealth as it may allow them to remove tax liabilities from their estate. This type of trust is often pursued by very high-net-worth individuals for estate planning purposes.

The benefits of an ILIT include:

• Mitigating estate taxes: The trust owns the insurance policy, so it can be excluded from your taxable estate and is therefore not subject to federal estate taxes.
• Eliminating gift taxes: The trust transfer can be treated as a present gift that may not be taxed.
• Preserving government benefits: It helps preserve eligibility for any beneficiaries who may receive asset-dependent benefits from the state or federal government.
• Protecting assets: It can limit the amount of money that creditors may pursue.
• Controlling distributions: Trusts allow you to control when and how beneficiaries are paid.
• Planning for generational legacies: Trusts can provide for future generations, including those who haven't yet been born, and help them inherit wealth in a tax-efficient manner.
• Shielding from tax penalties: The policy's cash value and death benefits may not be taxed.

Revocable Life Insurance Trusts (RLIT)

Revocable Life Insurance Trusts, also known as living trusts, can be altered, modified, or revoked by the grantor at any time. This type of trust gives you more control over your assets and is typically used by those whose financial needs may change.

The benefits of an RLIT include:

• Control over assets: You can change, amend, or terminate a revocable trust at any time and for any reason, giving you flexibility regarding the division of your assets.
• Estate planning: Trusts can help you control the flow of assets to minor children, young adults, or children with special needs.
• Tax benefits: While not as advantageous as an ILIT, an RLIT can still offer some tax benefits, depending on the circumstances.

Both irrevocable and revocable life insurance trusts offer unique benefits. Irrevocable trusts are ideal for those seeking to reduce estate taxes and shield assets from creditors, while revocable trusts offer greater flexibility and control over assets. It is important to consider your specific needs and goals when deciding which type of trust is best for you. Working with an experienced financial professional or estate planning attorney can help you make an informed decision.

How to fund a trust with life insurance

Funding a trust with life insurance is a popular method to secure your family's future. This involves a trustee who manages the assets for the beneficiaries. Here are the steps to set up a trust with life insurance:

Determine the Type of Trust:

There are two common types of life insurance trusts: irrevocable and revocable. Your financial situation and estate planning goals will help determine the right type for your needs. Irrevocable trusts cannot be changed, altered, or revoked, offering protection from creditors and estate tax benefits. On the other hand, revocable trusts offer flexibility and can be changed or revoked by the grantor at any time.

Choose the Beneficiaries:

After selecting the trust type, choose the beneficiaries who will benefit from the policy. Consider which family members or heirs should receive proceeds and specify how the money will be used, such as for college tuition or medical expenses. A life insurance trust is especially beneficial for children with special needs, ensuring their needs are met without affecting their eligibility for government benefits.

Calculate the Required Insurance Amount:

The next step is to calculate your life insurance needs based on your family's current and future finances. Consider factors such as inflation, estate taxes, funeral costs, and potential legal costs associated with administering the trust. An experienced financial advisor can help customize a plan that suits your requirements.

Select the Type of Life Insurance:

When establishing a life insurance trust, it is generally recommended to use a permanent life insurance policy that doesn't expire. However, if affordability is a concern, a term life insurance policy can be a more cost-effective option, although renewing it can be expensive. Consult a financial advisor to identify the right type of insurance for your trust.

Purchase the Life Insurance:

Shop around for life insurance quotes and consider policy fees and the growth rate of the cash value. Work with a financial advisor or insurance agent to understand the costs beyond the premium quote. The application process may include a medical exam and a review of your health and lifestyle habits. Remember to name the trust as the beneficiary to ensure proceeds are paid directly to it.

Transfer Ownership of the Policy to the Trust:

The final step is to transfer ownership of your life insurance policy to the trust. This typically involves signing a form from the insurance company and providing information about the trust. An estate planning attorney can ensure that all legal documents are correctly filed. Once ownership is transferred, the trust becomes responsible for premium payments, claiming the death benefit, and managing the policy.

Tax implications of a life insurance trust

Life insurance trusts can have significant tax implications, both during the grantor's lifetime and after their death. Here are the key tax considerations to keep in mind:

During the Grantor's Lifetime:

• Income Tax: The trust may be subject to income tax on the earnings of the life insurance policy.
• Gift Tax: If the grantor transfers assets to the trust, those transfers may be subject to gift tax. In the US, for example, there is an annual gift tax exclusion limit, and anything above that must be reported.
• Tax Benefits: Depending on the type of trust, there can be tax benefits. For instance, with an irrevocable life insurance trust, the death benefit is typically not subject to income tax for the beneficiaries.

After the Grantor's Death:

• Estate Tax: The death benefit of the life insurance policy may be subject to estate tax. However, with proper structuring, the death benefit can be excluded from the grantor's estate for estate tax purposes, reducing tax liabilities for the beneficiaries.
• Tax-Free Proceeds: In some cases, life insurance proceeds are not taxed as they go into the trust, especially with revocable trusts.

Given the complex nature of tax laws surrounding life insurance trusts, it is highly recommended to consult with an estate planning attorney or financial advisor to ensure compliance with applicable regulations and to optimise your tax position.

Frequently asked questions