Reduce estate taxes and enjoy control over benefit payments with a life insurance trust

In this series of articles of trusts, we are exploring the different trust options that are available and that may work best for you under different scenarios. If you are looking for an effective way to reduce or eliminate estate taxes while keeping all the death benefits from your life insurance policies, a life insurance trust may be the right choice for you.

What is a life insurance trust?

A life insurance trust is an irrevocable trust that allows you to have more control over your insurance policies. It gives you more flexibility in terms of how the insurance proceeds are paid out to named beneficiaries.

When you do not place your life insurance policies inside a trust, they are counted as an investment and an asset. This means that they are included in your estate after your death. If your combined assets exceed the estate tax exemption limit, you will be subject to estate taxes proportionate to the size of your estate. 

One thing to note: once you create the life insurance trust, you are no longer the owner of the life insurance policy. This may sound unsettling, but the idea behind it is that you will not have to deal with the inconveniences that stem from life insurance proceeds counting towards your estate.

How do I create a life insurance trust?

If you are the one creating the trust, you are the trust grantor. You will select both the trustee and beneficiary for the trust. The trustee is someone who manages the trust according to your instructions, and the beneficiary or beneficiaries are those who receive the assets or funds in the trust after you pass away. While the beneficiaries are usually your children or other family members for the majority of different trusts, you may decide to make yourself the beneficiary in a life insurance trust.

Choosing the trustee can be a complicated process, but you definitely do not want to name yourself as the trustee in a life insurance trust because it bars you from obtaining all the benefits of the trust. For example, if you are the trustee, the life insurance proceeds will count towards your taxable estate.

Therefore, some people decide to choose their spouse or adult children as trustees. However, they may lack the time and experience to manage the trust. Thus, many people turn to corporate trustees, such as banks or trust companies, because they are more experienced. Whoever you choose as your trustee is up for you to decide - the only thing you should remember is that choosing yourself is not a good option.

To establish the trust, you will start by instructing the trustee to purchase a life insurance policy. You are the named insured of this policy. When you pass away, the death benefits are paid to the trust. The trustee then manages the funds in the trust and pays any taxes or fees due: income taxes, estate taxes, debts, legal fees, etc. Then the remaining funds are distributed to the beneficiaries according to your instructions. 

You can also transfer your existing life insurance policy to the trust, but you need to remain alive for three years after the date of the transfer for it to be considered valid by the IRS. Otherwise, the insurance will be included in your taxable estate. There may also be a gift tax imposed. 

Why create a life insurance trust?

One question you might have at this point is, “Why create a trust when I could make someone else the owner of my insurance policy?” After all, both would help you avoid the insurance proceeds from counting towards your estate.

However, you need to remember that naming someone else as an owner of the insurance policy is very risky because you essentially lose control of the insurance. The owner of the insurance policy could potentially cancel the policy, change the beneficiary, or take the cash value. Even if you trust the person you are making the owner of your insurance policy, there are factors out of your control that may reduce the benefits you could potentially reap from the insurance. For example, the insurance proceeds could be used to satisfy the other person’s creditors. 

To review, the benefits of a life insurance trust are:

• It eliminates the need to go through probate, meaning your beneficiaries gain faster access to your money, sometimes within a couple of weeks of the death certificate being issued.

• It reduces your estate taxes or eliminates the need for them altogether because an asset (your life insurance) is no longer counted towards your estate.

• You can provide for your spouse and children without the insurance proceeds counting towards their estate.

• You have control over your insurance policy and how the proceeds are distributed even after your death.

If these benefits are appealing to you, but you have more questions, you may want to enlist the help of a legal professional. At Peacefully, we offer a vetted list of attorneys in your area, which you can access by clicking here.

For any other assistance in estate manatement, feel free to make use of the concierge service here at Peacefully. We assist with referrals to trusted professionals, offer case-specific advice, recommendations, and coordination for you. For more about our concierge service or to schedule a free consultation, click here.

— Lucy Jung