Life insurance policies and trusts can be combined in estate planning to help people protect their assets and protect the financial futures of those most important to them.
Life insurance trusts are created when an individual (called a grantor) transfers ownership of their term or whole life insurance policy to a trust. The trust owns the insurance policy and a third-party trustee manages its benefits. When the insured person dies, the death benefit is paid to the trust, and the trustee distributes the funds to beneficiaries according to the terms of the trust document. One of the advantages of life insurance trusts is that they give the grantor the ability to decide how and when the assets are distributed to the beneficiaries. For example, the trust can set specific conditions for the release of funds to different beneficiaries such as reaching a certain age or completing an education milestone.
Trusts, in general, can be funded with life insurance or other assets. They are often perceived as a financial strategy mainly used by the very wealthy to minimize estate taxes. However, they can be beneficial even to those who are not wealthy. This is particularly true if the grantor or grantors of the trust have young children or children with special needs and want to manage the distribution of assets if they pass away unexpectedly.
Funding Life Insurance Trusts
When creating a life insurance trust, it is possible to use either term or permanent policies as the underlying coverage. There are important distinctions between these two types of policies. Term policies only pay a death benefit if the insured dies during a specified range of years, perhaps 15, 20 or 25 years from the policy start date. Also, term policies do not build cash value over time and they expire after the term is up. Permanent policies, also known as whole life policies, do not expire as long as the premium is paid. They build up a cash value which can be withdrawn in the form of a policy loan during the life of the insured.
While technically either type of policy can fund a life insurance trust, permanent or whole life insurance is preferred. This is because if a term policy is used, the term might expire before the insured person dies leaving the trust without any death benefit to distribute to beneficiaries. This could leave the beneficiaries in a challenging financial position which is not usually the intention of the grantor. Permanent universal policies known for having flexible premiums and fluctuating death benefits, are usually also not chosen for life insurance trusts as they can result in the trust being underfunded.
Types of Life Insurance Trusts
Trusts can have different characteristics, such as being irrevocable or revocable, and they can serve different purposes while providing varying levels of control and flexibility. Regardless of the type of trust, the trust itself will own the life insurance policy and the trustee will manage the assets while the insured is alive. The trustee then distributes the death benefit to the beneficiaries after the insured’s death, typically according to a set plan outlined in the trust documentation.
Irrevocable trusts, as the name suggests, cannot be modified or canceled once they are established. The grantor will have given up ownership and control, and will not have access to the cash value of the policy for any purpose, such as funding their retirement. However, relinquishing control of the assets in a trust can be beneficial for those with significant wealth, as it can help remove certain tax liabilities from the estate.
By transferring a life insurance policy to a trust, the grantor avoids owning the policy and thus will not have it included in her estate for estate tax purposes. Another reason is to eliminate gift taxes, by giving a new policy with no cash value to an irrevocable life insurance trust, it is considered a present gift for tax purposes instead of a taxable future gift. Additionally, an irrevocable life insurance trust (or ILIT) can help preserve the grantor’s eligibility for Medicaid, protect assets from creditors, control distributions to beneficiaries, plan for generational legacies and shield the grantor from tax penalties.
Not every grantor can afford to use an irrevocable trust for their life insurance policy. Because the cash value of the policy will be inaccessible by the grantor, if the grantor anticipates a need to take the growing cash value out of the policy during his lifetime, a revocable trust may be a better choice. This is because revocable trusts give grantors more control over assets.
“By transferring a life insurance policy to a trust, the grantor avoids owning the policy and thus will not have it included in her estate for estate tax purposes.”
Revocable life insurance trusts allow the grantor to have more control over the policy. They can make changes, alterations, or even cancel the trust at any time for any reason. This allows for flexibility with how the assets are divided, as the grantor can adjust the policy as circumstances change. Revocable trusts are frequently used to manage the distribution of assets to minors, young adults, or children with special needs. For instance, if a grantor is concerned about then wisdom of leaving a large amount of money to an 18-year-old, a trust can help ease these worries by releasing the inheritance in smaller increments over a longer period. This can prevent the beneficiary from spending all of the inheritance at once. While life insurance is not required to create a trust, it can be a useful way to fund these trusts as the benefits are paid out quickly (usually within a week or two after the insured’s death). Life insurance funding eliminates delays and uncertainty with estate administration and allows other estate assets such as a house or stocks to be sold when the timing is more favorable.
A revocable special needs trust is an option to consider if you have a child with special needs who will need long-term care. This type of trust holds money for your child and outlines how and when it should be used. The benefits of a life insurance policy paid into the trust are tax-free and the trustee is in charge of managing those funds and distributing them according to your instructions. By having the trust own the assets, it can help preserve your child’s eligibility for important government benefits, such as Medicaid, which are based on financial need.
The Importance of Professional Advice
It is important to consult both a financial planner and an estate planning attorney when creating a life insurance trust because both professionals have specific areas of expertise that are essential for ensuring the trust is set up correctly and achieves the intended goals.
A financial planner can help with the financial aspect of setting up the trust. They can help grantors determine how much life insurance coverage is needed, which insurance carrier to use and how to set up payments to beneficiaries. They can also help grantors understand how a trust will impact their overall financial plan. A licensed financial planner will not charge a grantor for this service. Instead the financial planner would be compensated by the insurance carrier that the grantor ultimately chooses to provide the policy.
An estate planning attorney, on the other hand, has expertise in the legal and tax aspects of estate planning. They can help grantors understand the legal requirements for setting up a trust and ensure that the trust documents are properly drafted and executed. They can also explain the other legal aspects such as: how to name the trustee, how to structure the trust to meet your objectives, how to avoid probate, how to preserve government benefits, how to protect assets and how to control distributions. Attorneys do charge for their services, and an experienced financial planner can advise grantors at no cost as to which attorney delivers the best value.
Working with both a financial planner and an estate planning attorney can help ensure that the life insurance trust is set up correctly and that it meets the grantor’s needs and objectives. They can work together to make sure that the trust is well-structured and that it will achieve the grantor’s legacy goals while minimizing tax and legal complications.
Parker Lake – Financial Planning, Risk Management and Asset Protection
Being able to leave a legacy is a crucial part of financial planning. I work closely with experts in tax and estate planning to manage and protect the assets including life insurance policies that are held in trust. While working with advisors can typically be costly, one advantage of working with me is that my services are free to my clients. This is because in the case of helping you to choose a life insurance policy that best fits your legacy goals, I would be paid by the insurance carrier. Another benefit is that I represent a wide range of financial institutions and can provide several options from different providers.
If you are looking for a sound financial plan for you, your family or your business reach out to me today by calling (305) 613-1498, via my contact form or by booking a consultation directly into my calendar.