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How do I set up a life insurance trust?

Treat the trust as an estate planning tool — learn about its tax advantages and other benefits.

A life insurance trust holds on to your assets and passes them on to your loved ones when you die. It can help you to maintain control over your policy while making sure it isn’t counted as part of your estate — but choose your beneficiaries wisely.

What is a life insurance trust?

A life insurance trust is both the owner and beneficiary of one or more life insurance policies. Here’s how it works:

  • The grantor creates the trust. Let’s say that’s you.
  • You choose a trustee to manage the trust, and leave instructions for how the money should be spent and allocated after you die. You can decide whether you want to release the money to your beneficiaries as soon as you pass away, or wait until they reach a specific milestone, like their 21st birthday or college graduation. You can also choose between having the funds paid out in a lump sum, or in smaller amounts over a period of months or years.
  • The trustee purchases a life insurance policy, with you as the insured, and the trust as the owner and beneficiary. To keep the policy in force, the trust must continue to pay the premiums.
  • When you die, the trustee will collect the proceeds from your life insurance policy, and distribute the money to your beneficiaries according to your instructions.

The main reason to open an irrevocable life insurance trust (ILIT) is the tax advantage. Since the trust owns the policy — and not you — it’s not considered a part of your estate. This means that the proceeds aren’t subject to probate, income or estate taxes.

What’s the difference between an irrevocable and revocable trust?

You can’t change an irrevocable trust. Once you’ve signed the dotted line, that’s it.

A revocable trust can be amended or even revoked. But if you decide to open a revocable trust, you’ll lose the tax benefit. When you die, the proceeds from your life insurance policy will be included in your estate — which means your heirs may have to pay estate taxes.

Most life insurance trusts are irrevocable.

Who should I name as my beneficiary?

When you create a trust, you can name any person or organization as beneficiary. Most people name their spouse, children or grandchildren, and the death benefit is exempt from estate and income taxes. You might want to designate a secondary (or contingent) beneficiary, too, just in case the primary beneficiaries die before you do. That way, the life insurance trust will allow you to pass as much of your estate as possible to your heirs.

If you’re opening an irrevocable life insurance trust, keep in mind that those beneficiaries can’t be changed, so choose them carefully.

Why not name someone else as the owner of my policy?

Transferring the ownership of your policy to another person can be tricky. With a trust, you have some legal control over your policy, and you get to decide who benefits from it.

If you name someone else as the owner of your policy, you’re giving up control. The new owners can do anything they like with it, including cashing it in, changing the beneficiaries, or even canceling the policies — leaving you with no insurance. An ownership transfer can’t be reversed, either. This could pose problems if, for example, you get divorced and your ex-spouse owns your policy.

Plus, if the new owner of your policy dies before you do, the proceeds of the policy will end up in their taxable estate.

Generally, a trust is the safer choice.

Advantages of a life insurance trust

These are the major benefits of a life insurance trust:

  • Offers tax advantages. Depending on how much your estate is worth, a trust can help your beneficiaries to skirt or reduce estate taxes.
  • Provides flexibility. As the grantor, you set the conditions for your trust, including how the funds are allocated and when they’re distributed.
  • Gives your beneficiaries a financial safety net. A trust can give your beneficiaries the cash they need to pay taxes, debts and other expenses after your death.
  • Allows you to maintain control over your insurance policy. You’ll no longer own the policy, but you can decide how the proceeds are distributed when you die.
  • Stops the court from controlling the proceeds of your policy if your beneficiary is incapacitated. Usually, your life insurance company would ask the court to step in. But in this case, your trustee can use the proceeds to provide for your loved ones.
  • Avoids other taxes. Your beneficiaries won’t need to cough up probate or income taxes.

Disadvantages of a life insurance trust

There are a couple of potential downsides to creating a trust:

  • Might be expensive to maintain. Establishing a trust may set you back hundreds or even thousands of dollars, depending on where you live.
  • Can be complicated. Between terms and beneficiaries, setting up a trust can be a complex process. If you don’t have too many assets to protect, a simple will could be an affordable alternative to a trust. While you can create a will for free online, just be sure it’s ironclad to prevent your loved ones from ending up in a legal battle when you’re gone.

How a life insurance trust can help you to avoid estate taxes

When you own your life insurance policy, the death benefit is included in your estate. If your estate is worth $11.58 million (the 2020 threshold) or more, your beneficiaries might need to pay estate taxes when you die.

On the other hand, if your policy is owned by an ILIT, the proceeds aren’t counted as part of your estate. Therefore, they won’t be subject to state and federal estate taxes. But the ILIT can give your beneficiaries the liquid cash they need to pay estate taxes on your other assets, as well as any debts and expenses.

Alternatives to a life insurance beneficiary trust

If ILIT trusts are too complex or pricey for you, there are a few other ways to pass down assets to your loved ones:

  • Create a last will and testament. A will contains instructions for how you’d like your assets to be distributed and should happen to your minor children if your spouse dies.
  • Buy a life insurance policy. When you die, your beneficiaries will receive a guaranteed death benefit. The proceeds from your policy aren’t subject to taxes or probate.
  • Name a beneficiary for your accounts. You can nominate a beneficiary to get the funds from your bank, brokerage and retirement accounts when you die. This is known as a “payable-on-death” account.

What is a testamentary trust?

Create a trust as part of your will — and this is called a “testamentary trust.” In the will, you can specify which assets should go directly to your beneficiaries, and which ones you’d like to place in the trust. You can also use your will to transfer assets into an existing trust.

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Bottom line

Life insurance trusts can be a powerful estate planning tool. Since you maintain some legal control over the policy, you can decide who benefits from your policy when you die — and how much money they get. But most life insurance trusts are irrevocable, so they’re set in stone.

If you’re in the market for life insurance, take the time to compare life insurance companies and policy features.

Frequently asked questions

What is a special needs trust?

A special needs trust is designed to provide for a child with a disability when you die. Typically, people with disabilities only qualify for government assistance programs if they have less than $2,000 in assets to their names. A special needs trust can hold money and property — including a life insurance policy — for your child while making sure they still benefit from federal and state health insurance as well as Supplemental Security Income.

What kind of coverage can my trustee buy?

They can buy any term or permanent policy. But the beneficiaries will only receive a death benefit from the trust if the policy is active, so most people go with whole life, universal life, or another policy that offers lifelong coverage.

How do I dissolve an ILIT?

There’s a roundabout way. If the trustee or another individual stopped paying the life insurance premiums, the policy would lapse — leaving the trust empty.

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