Life insurance trusts

A trust comes with many tax advantages, making it appealing for those with large estates.

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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.

What to consider when naming beneficiaries

When you create a trust, you can name any person or organization as the beneficiary. Most people name their spouse, children or grandchildren. You might want to designate a secondary (or contingent) beneficiary, too, just in case the primary beneficiaries die before you do.

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.

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 $11.4 million (the 2019 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.

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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 providers and policy features.

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