When to Consider a Life Insurance Trust

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Life insurance can bring great peace of mind while you’re alive—and financial security to the loved ones left behind when you die. But in some situations, such as when you have a very sizable estate or want to pass on money to a minor child, naming an individual as the direct beneficiary of a policy can create unintended complications. In those cases, establishing a life insurance trust may make sense.

What is a life insurance trust?

For the vast majority of life insurance policies, the beneficiary is an individual. That means when the policy holder dies, the death benefit is paid out to the beneficiary directly (in either a lump sum or as structured payments), and that benefit isn’t taxed. A life insurance trust works differently: You establish the trust and set up clear instructions for when and how the money is to be disbursed. The trust then oversees those funds until the entirety has been paid out. A life insurance trust could exist for years—even decades—after your death.

When considering a trust, you’ll choose between two types: revocable (which means you can change the terms at any time) or irrevocable (which means once you set up the trust, you cannot make changes). While a revocable trust offers more flexibility, your financial planner or estate attorney might recommend an irrevocable life insurance trust for the far greater tax benefits involved.

When does a life insurance trust make sense?

There are two main reasons that people turn to life insurance trusts: to avoid taxes on sizable estates and to structure payouts for minor children.

Life insurance trusts can avoid estate taxes

Death benefits on life insurance policies become subject to federal estate taxes if the policy holder has “incidents of ownership” in the policies or if the proceeds are payable to the estate. Examples of “incidents of ownership” include the policy holder’s right to change beneficiaries, to borrow the cash value, to select dividend options, or to change premium payment schedules. That means you may have to pay estate taxes on the insurance proceeds, if the estate exceeds the estate tax exemption threshold. At the federal level, that was recently doubled, to roughly $11 million for someone who was unmarried or $22 million for married couples for the years 2018-2025. 

But at the state level, even smaller estates may face state taxes. Not all states have estate taxes, but those that do tend to have exemptions far below the federal limit. In Massachusetts and Oregon, for instance, the estate tax exemption is a relatively small $1 million. In Illinois, it’s $4 million; Maryland, it’s $3 million; in Vermont, it’s $2.75 million; in New Jersey, Washington, Connecticut, and Minnesota, it’s $2 million; and in Rhode Island, it’s $1.5 million.

With an irrevocable life insurance trust, you can either purchase a policy and then transfer its ownership to a trust, or the trust can purchase the policy directly. Either way, because the trust technically owns the policy and is the beneficiary of the policy, the death benefit is not considered part of your estate when you die and cannot be hit with estate taxes. (That’s not true with a revocable life insurance trust—the death benefit is considered part of the estate’s assets and could be used to pay outstanding bills, creditors, and taxes.)

There are, however, trade-offs to establishing an irrevocable life insurance trust: The documents that establish the trust will also appoint a trustee to administer the trust’s assets as indicated. The document will also indicate who the beneficiaries are, just like an insurance policy owned by an individual. But unlike policies owned by individuals, for which you are encouraged to regularly review and change the beneficiaries as needed, the instructions stipulated when the trust is created are final. That means you cannot make any changes to the trust once it’s established. You can, however, appoint your spouse, children or friends as trustees to make necessary changes.

The child-related perks of trusts

Even if you don’t have a sizable estate, a life insurance trust may be the most effective way to ensure your minor children benefit from your policy proceeds. That’s because minors can’t actually receive life insurance payouts directly. Instead, the courts will typically appoint a guardian to oversee the death benefit—which can be a costly and time-intensive endeavor. And when your kids reach the age of maturity (typically 18 or 21, depending on where you live), they receive any remainder as a lump sum payment.

With a life insurance trust, you’ll have more say over how the funds are used and when your kids have access to them, even after they become adults. When you establish the trust, you can spell out how the proceeds should be managed and appoint a trustee to oversee the process. Want to keep your kids in private school? Need to earmark extra funds for treatments for a child who has special needs? Think your kids shouldn’t receive any major windfalls until they’re 25? You can detail all of those desires in the trust, and the trustee will ensure that your wishes are followed.

Types of trusts

Life insurance trusts can either be funded or unfunded. A funded trust, which is less frequently used due to the possible application of a gift tax, may include the policy as well as additional assets. Meanwhile, an unfunded trust includes only the insurance policy. Each year, you, as the grantor, make contributions to the trust to pay the policy’s premiums. While the trust exists in perpetuity, you can stop funding premiums (though this will void the death benefit).

These issues can be complicated, and it’s always a good idea to consult a financial advisor, and select an attorney who specializes in estate planning to help you establish the trust. In some states, you’ll also need to file a copy of the trust paperwork with the secretary of state’s office.

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