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Life insurance can help you financially protect your dependents and loved ones who rely on you. Your policy's death benefit can help provide for your family if you suddenly pass. But what if the death benefit must pass through a lengthy probate process? What if you want to avoid or minimize estate taxes so your heirs have more funds at their disposal?
In scenarios like these, you may want to support those you leave behind even more with a trust. A life insurance trust, often called simply an insurance trust, is a trust you fund with life insurance that ensures your death benefit is paid out to your beneficiaries in whatever fashion or timeline you wish.
How Does a Life Insurance Trust Work?
The purpose of an insurance trust is to create a legal entity you can transfer your life insurance policy into. Once transferred, your policy's death benefit isn't part of your estate, which can reduce your estate tax liability. Also, you'll have a clear plan for distributing your assets rather than letting probate courts make those decisions, which could delay your beneficiaries from receiving their inheritance.
Here's how it breaks down:
- The trust owns the life insurance policy, including the death benefit. The insurance premiums still must be made. A common way to pay premiums is via "gifts." In this case, you pay the trustee, who deposits the payments into the trust's checking account. The life insurance policy premiums are then paid from this account.
- Upon your death, the death benefit is deposited into the trust. Your designated trustee will disburse the funds according to the instructions you set forth in the trust.
- The trustee manages the trust. You'll want to designate someone reliable who agrees to serve as the trustee.
- Distribution of property and assets can be unique to suit your needs. They can be disbursed whenever you wish. For instance, if you have minor children, you may instruct funds to remain in the trust until the child's 25th birthday, or perhaps earlier if you want funds to be used for college or other major goals.
You can include a term life insurance policy in your trust, but permanent life insurance is more common since its coverage should never expire as long as the premiums are paid on time. On the other hand, term coverage, by definition, is set to expire, which could leave your trust without funds.
Types of Life Insurance Trusts
There are two types of life insurance trusts: irrevocable life insurance trusts (ILITs) and revocable life insurance trusts (RLITs). Both types of trusts allow your trustee to distribute funds from the trust to specific beneficiaries according to your directions. Generally, this setup is preferable to a non-trust arrangement, in which your property goes through probate court, which can be a lengthy and expensive process.
It's helpful to understand the differences between irrevocable life insurance trusts and revocable ones, as illustrated below:
| Irrevocable vs. Revocable Life Insurance Trusts | |
|---|---|
| Irrevocable Life Insurance Trusts (ILIT) | Revocable Life Insurance Trusts (RLIT) |
| Changes are forbidden once the trust is established. | Changes are allowed as needed by the grantor (usually the policyholder). |
| The trust owns all assets included within it. | The insured controls the trust and its assets. |
| Federal estate taxes may be avoided if the estate's value doesn't exceed the 2024 federal limit of $13.61 million. An estate will be taxed on amounts that exceed this threshold. State tax liabilities vary by state, but 33 states don't impose estate tax. | Since the insured retains control of trust, it may be subject to taxes. |
| Creditors may not pursue assets as debt payment except in cases of fraud. | Creditors may pursue assets for debt collection depending on your state laws. |
Pros and Cons of Life Insurance Trusts
Consider the benefits and downsides of life insurance trusts to help determine if creating one makes sense for you and your family.
Advantages of Putting Life Insurance in a Trust
- It reduces your estate tax liability. Once you assign ownership of your insurance policy to your ILIT, your insurance policy is separated from your estate. As such, federal estate taxes or estate tax penalties may be reduced or eliminated.
- It helps protect your assets. With an ILIT, creditors may not pursue your assets except in cases of fraud. Depending on your state laws, an RLIT may allow creditors to go after your assets to collect on debt obligations after you die.
- It enables you to bypass probate and direct distributions. With both revocable and irrevocable life insurance trusts, you can assign a trustee to distribute assets however you want, and beneficiaries may receive proceeds much sooner than if your assets go into probate.
- It can help preserve family wealth. Many high-net-worth individuals use irrevocable trusts to protect their wealth across multiple generations by utilizing the tax-advantaged transfer of assets.
Disadvantages of Putting Life Insurance in a Trust
- It requires you to give up control. You can set up an irrevocable life insurance trust to ensure your property, financial assets and other valuables are distributed exactly how you want. However, once your policy is transferred into the ILIT, you can't move your insurance policy to a different trust or make other changes as you could with an RLIT—though you may change the trustee if needed.
- It could be costly. Creating an ILIT through an estate or trust attorney could cost a few thousand dollars. A revocable life insurance trust may be more affordable and less complicated to set up. You might consider this option if your estate is modest and your distribution plan for your assets is relatively straightforward.
How to Set Up a Trust for Life Insurance
Follow these steps to set up a life insurance trust to help ensure your policy's death benefit and financial assets are allocated according to your plan.
- Consult an estate attorney or use estate planning software. Legal software is available for do-it-yourselfers to set up a life insurance trust. This option may be sufficient for someone with a more moderate estate and minimal asset distribution needs. However, you may prefer working with an estate attorney to guide you through the process and address potential future issues you might not have considered.
- Designate roles for the trust. Assign a trustee for the life insurance trust you can rely on to execute the details of your estate plan. Before finalizing your trust, discuss your estate wishes with this person and make sure they agree to serve as trustee. Your plan will also require you to name your beneficiaries, whether they are people or organizations. Finally, appoint a financial manager to oversee the inheritance for any beneficiaries who are minors.
- Draw up the trust. Although legal software can help you set up your life insurance trust, it's generally recommended to work with an estate planning attorney to create your documents. An attorney with experience establishing life insurance trusts can help you design a trust customized to your unique financial needs and make sure the documents are filed correctly.
- Fund the trust. Since life insurance trusts are funded by a life insurance policy, look for a term or whole life insurance policy that provides sufficient coverage for your beneficiaries. Also, determine the appropriate amount of life insurance you need so your loved ones can financially survive once you pass.
The Bottom Line
Setting up a life insurance trust may be worth it because it can help you transfer wealth to your heirs in a tax-efficient way. Instead of leaving your estate to the whims of the probate process, a trust can help ensure your plans for your property and assets are distributed according to your wishes.
Understandably, making end-of-life plans may not be your idea of fun, but your heirs will appreciate having a clear plan to secure their financial future and avoid potential legal issues. Consider working with a financial advisor or estate planning attorney to design a plan that best serves your unique needs.