Life Insurance Trust: Protecting Your Family's Future

Life insurance is a crucial financial product that provides peace of mind and security for your loved ones after you're gone. One way to ensure your beneficiaries receive the full benefits of your life insurance policy is to place it in a trust. A trust is a legal arrangement where a trustee manages the assets on behalf of your chosen beneficiaries. By placing your life insurance policy in a trust, you can secure several advantages for your family, including tax benefits, controlled distribution, and protection from probate.

There are two main types of life insurance trusts: irrevocable and revocable. An irrevocable life insurance trust (ILIT) offers greater benefits in terms of tax savings and asset protection but cannot be changed or revoked once established. On the other hand, a revocable life insurance trust (RLIT) provides flexibility as it can be altered or cancelled by the grantor at any time.

By placing your life insurance policy in a trust, you can ensure that the proceeds are distributed according to your wishes, even if your beneficiaries are minors or lack financial maturity. Additionally, a life insurance trust can help reduce estate taxes, shield assets from creditors, and provide liquidity to pay off debts and final expenses.

It's important to consult with financial and legal professionals when considering a life insurance trust to ensure it aligns with your unique circumstances and goals. They can guide you through the process, including choosing the right type of trust, selecting a trustee, and transferring ownership of the policy to the trust.

Reduce estate tax liability

If you own your life insurance policy at the time of your death, its value is included in your estate and may be subject to estate tax. This means more of your money will go to the government instead of your loved ones. Putting your life insurance policy in a trust is one way to avoid this.

Note that only an irrevocable life insurance trust (ILIT) works in this way for tax purposes. While a revocable life insurance trust may be an option, it won't have any effect on estate tax liability. An ILIT is a complex legal arrangement that requires properly drafted documentation. The cost incurred to create and administer the trust means it's not appropriate for every situation.

Compared to owning the life insurance policy personally, a key advantage of an ILIT is that the assets it owns will not be considered part of an estate for federal inheritance/estate tax purposes. Consequently, heirs won't have to pay estate or inheritance taxes on the life insurance death benefits that are paid.

If you die within three years of transferring your policy to an ILIT, the Internal Revenue Service considers the trust to be invalid, and the value of the policy will be included in your estate.

If you already own one or more life insurance policies, you can change ownership from your name to your insurance trust. First, work with an estate planning attorney to create the trust document. Then, get a change of ownership form from your insurance broker or company and submit it once completed. At the same time, you may also want to name the trust as the beneficiary.

If you don't already own an insurance policy, the most effective way to proceed is to create an insurance trust first. The trust should then apply for insurance on your life and will be the original owner when the policy is issued, meaning the insurance amount will be outside of your estate from the start.

Control the proceeds

One of the main advantages of placing a life insurance policy in a trust is to control how the proceeds are distributed. With a life insurance policy not held in trust, the proceeds are typically paid out to the beneficiaries in a single lump sum upon the policyholder's death. However, there are several reasons why the policyholder might not want their beneficiaries to receive the entire sum all at once.

For example, the beneficiaries may be minors or adults with disabilities who are unable to manage their finances independently. In such cases, a life insurance trust allows the policyholder to set specific terms and limitations on how and when the beneficiary may access the funds. The policyholder might prefer that the funds are used for specific purposes, such as college tuition, a wedding, or a down payment on a home.

Additionally, the policyholder may have concerns about the age, maturity, or financial responsibility of their beneficiaries. They may fear that the proceeds could be seized by creditors or that a lump sum payment might negatively impact their beneficiaries' financial future. By placing the policy in a trust, the policyholder can dictate that the trustee distribute the proceeds in instalments—monthly, annually, or upon reaching certain milestones.

Furthermore, a life insurance trust can help beneficiaries maintain their eligibility for government benefits, such as Medicaid. The policyholder can stipulate that proceeds are not to be distributed for basic needs such as food, shelter, or clothing, but rather for other purposes such as education or entertainment. This helps to ensure that the beneficiary's government benefits remain intact.

Provide liquidity to your estate

Life insurance trusts can provide liquidity to your estate by ensuring your heirs have the funds to pay estate taxes without having to sell off assets like real estate or a business.

Life insurance trusts can be a powerful tool for estate planning, helping to ensure your policy is used in the best possible way to benefit your family. They can be particularly useful if you have a large estate and want to reduce the amount of tax paid on the life insurance benefits passed from the grantor to the beneficiary.

If you own a life insurance policy, you may know that the beneficiaries you name to receive the insurance proceeds when you pass away will get that money income tax-free. However, the payout on a life insurance policy may not be exempt from estate tax. This is why planners often recommend that a trust own your life insurance policy instead of you owning it.

If you put your life insurance policy into an irrevocable trust, the proceeds from the death benefit are not part of the insured's gross estate and thus not subject to state and federal estate taxation. If properly drafted, the trust can provide liquidity to help pay estate taxes, as well as other debts and expenses, by purchasing assets from the grantor's estate or through a loan.

In addition to reducing estate taxes, life insurance trusts can also provide liquidity by protecting the death benefit from creditors and judgments. They can also help your heirs avoid the probate process, which can be lengthy and costly, and give you more control over how the payout is handled. For example, you could specify a specific age at which your children would receive the payout.

It's important to note that setting up a life insurance trust may involve high legal fees due to its complexity. There is also a risk of invalidating your life insurance policy if you need to make amendments to the trust. Additionally, if the grantor dies within three years of setting up an irrevocable insurance trust, it may be included in their estate and therefore subject to taxes.

Protect the death benefit from creditors and judgments

Life insurance policies are protected from creditors in most states. However, if the death benefit becomes part of your estate, creditors can make a valid claim to the money. This can happen in the following scenarios:

• If all of your beneficiaries die before you and you never name new ones.
• If you list your estate as a beneficiary on your policy.
• After you die, your estate may go through probate court, which determines where your assets go, including the death benefit from your policy if you didn't name any beneficiaries.

To protect your death benefit from creditors and judgments, you can place your ownership of any life insurance in an irrevocable life insurance trust (ILIT). By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 40%. Revocable trusts will not qualify for this exclusion.

An ILIT is a type of trust that holds and manages life insurance policies. The trust is "irrevocable" in the sense that it can't be changed or canceled after it's been set up. While this means you won't be able to change or revoke the trust once it's in place, establishing an irrevocable trust offers benefits such as avoiding estate taxes and any claims from creditors.

In addition to shielding assets from creditors, an ILIT can also help you reduce estate taxes and control how the death benefit payout is distributed. With an ILIT, you can dictate that the trustee distribute proceeds monthly or annually or even upon reaching certain milestones. You can also specify how the money is to be used, such as for college tuition or medical expenses.

To summarise, by placing your life insurance policy in an ILIT, you can protect the death benefit from creditors and judgments, reduce estate taxes, and gain more control over how the proceeds are distributed.

Avoid probate

Life insurance in trust can help your beneficiaries avoid probate, a lengthy legal process that involves distributing your estate after your death. Probate can take months to complete, delaying access to funds for your beneficiaries. However, if your life insurance is in trust, your beneficiaries can receive the payout without having to wait for probate. This is because the life insurance payout is managed by trustees and is not considered part of your estate. As a result, your beneficiaries can receive the funds quickly, often within a few weeks, by simply providing your trustees with a death certificate.

In addition to speeding up the payout process, life insurance in trust also provides other benefits. It gives you more control over who receives the payout and how it is distributed. You can specify the beneficiaries and set conditions, such as requiring the beneficiaries to reach a certain age before receiving the funds. Life insurance in trust also helps minimise or avoid inheritance tax, as the payout is not subject to the 40% inheritance tax on estates worth more than £325,000.

While life insurance in trust offers several advantages, there are also some potential drawbacks to consider. Setting up and managing a trust can be complex and may require legal assistance. Additionally, placing your life insurance in an irrevocable trust means you can't change or cancel it. There may also be initial and ongoing costs associated with establishing and maintaining the trust, such as legal fees and trustee fees.

Frequently asked questions