Life Insurance Trusts: A Frequently Overlooked Solution
When it comes to estate planning, most people at least know about the basic tools. Everyone has heard of a will, and even if they don’t realize it, many individuals have designated beneficiaries for certain accounts. However, a significant number of people overlook life insurance trusts — which is somewhat of a travesty. Everyone should consider utilizing life insurance trusts for effective estate planning.
Why don’t most people use these trusts? For one, only about half of Americans actually have life insurance — a clear prerequisite for creating such a trust. However, it’s also the case that most people don’t realize they can place their insurance assets into a trust. Once this misconception is overcome, those who are planning for the future secure major benefits via life insurance trusts.
How Does a Life Insurance Trust Work?
Life insurance policies allow individuals to leave something behind for their loved ones. In some instances, this could be a major financial influx. In other situations, it may merely be enough to cover funeral and burial costs. Whatever the specifics of a plan, both the policy and the proceeds can be transferred to, held, and managed by a trust.
This offers a variety of advantages over a life insurance policy merely held by the insured. For instance, transferring ownership of the policy to the trust can exclude it from the estate. This has the potential to greatly reduce estate taxes. Additionally, annual gift tax exclusions can offset the gift taxes required for premium payments.
The grantor of the trust can also specify how they want the proceeds distributed and managed. Policy proceeds can also be used to pay debts, estate taxes, and other expenses while offering a high level of protection from creditors. These benefits and many others are secured by simply starting a new policy or transferring an existing policy to a trust.
Revocable vs Irrevocable Life Insurance Trusts
When most people discuss life insurance trusts, they’re referencing the irrevocable version of this planning tool. That’s because it’s irrevocable trusts that offer many of the benefits — such as reduced taxes and creditor protection — that make these legal arrangements attractive for estate plans. However, it’s also possible to create a revocable life insurance trust.
An irrevocable trust cannot typically be altered or revoked, and it’s the trust that owns the life insurance policy. Conversely, a revocable life insurance trust can be altered or revoked by the grantor — and the grantor usually maintains ownership of the policy. Put simply, revocable trusts give more control while irrevocable trusts provide better asset protection.
If you’re wondering which approach is best when utilizing life insurance trusts for effective estate planning, there is no one-size-fits-all answer. It’s important to review your underlying goals and your own unique circumstances. Either revocable or irrevocable trusts can be a great option — you just need to figure out which offers the most benefits in your situation.
Creating a Life Insurance Trust
Regardless of the type of trust a person opts for, the benefits are undeniable. Both revocable and irrevocable life insurance trusts offer probate avoidance, privacy, and the ability to choose how policy proceeds are distributed. Once you’ve chosen the right legal arrangement for your situation, there are important steps you’ll need to take to get started.
These include:
Drafting the Agreement
You must first draft the trust document. It’s highly advisable to do this with the help of an attorney. This document will outline trust terms, trustee powers, beneficiaries, and distribution instructions. Even a simple mistake can prove disastrous.
Transfer the Policy
If you don’t yet have a life insurance policy, you can purchase one with the trust listed as the owner and beneficiary. If you already have an existing policy, you can transfer it to the trust. However, keep in mind that transferring a policy may result in gift tax issues and a three-year look-back period for estate tax purposes.
Funding the Life Insurance Trust
Grantors will need to make annual gifts into their trust so there’s funding to pay insurance premiums. You may be able to reduce or eliminate gift tax liability if these gifts qualify for the annual gift tax exclusion. You can use “crummey letters” to let beneficiaries know they have the right to withdraw gifted funds — thus ensuring that the gifts qualify for the annual exclusion.
Administering the Trust
The trustee will need to continue administering the trust. They’ll have to follow the terms, pay premiums, file necessary tax documents, and distribute proceeds once the insured passes on.
Important Considerations
There are some important things to know if you plan on utilizing life insurance trusts for effective estate planning. For one, these are incredibly complex documents. There are specific legal requirements necessary for creating a trust, and once this is done, managing the trust can be just as complicated. After all, tax laws and trust administration requirements don’t offer much flexibility. This means you should consider all your options.
It’s also worth noting the drawbacks of these trusts. If you opt for a revocable trust, you’re losing many of the benefits that attract people to these tools in the first place. However, opting for an irrevocable trust means you give up considerable control. You likely won’t be able to make changes without approval from the beneficiary. What happens when your desired changes stem from disputes with those beneficiaries?
The best way to avoid probate — and get the most out of your efforts when utilizing life insurance trusts for estate plans — is to work with an attorney. A legal professional can review your situation, discuss your goals, and help you understand the most ideal approach when planning for the future. At Celaya Law, our dedicated legal team is here to assist. Contact us at 707-754-0977 to discuss your options.