Estate planning is one of the most important ways to protect your family’s future. Without a wealth management plan, your loved ones may have to endure the complex process of recouping assets, paying estate taxes, and managing finances when you are gone. While a life insurance policy can help your family financially, it doesn’t always afford you total control over your assets when you die.
How Life Insurance Trusts Work
A life insurance policy is considered an investment and an asset. This means it is included in your aggregate estate when you die. Because of this, your death benefit becomes taxable if the total value of your assets surpasses the maximum exemption amount set by the federal government ($12,060,000 in 2022).
An irrevocable life insurance trust (ILIT) is an agreement between the grantor (you) and a life insurance company. It allows you to place your insurance policy into a trust, meaning you are no longer the owner of the policy.
Since you don’t own the policy, it is not included in your estate, making it exempt from estate taxes. Instead, you must name a trustee to assume responsibility for managing your policy, distributing your assets, and allocating the death benefit to your beneficiaries when you pass away.
Trust beneficiaries are the individuals entitled to the death benefit from your life insurance. All trust beneficiaries must be named when setting up your insurance trust.
Essentially, an irrevocable life insurance trust (ILIT) is designed to reduce the value of your taxable estate. This is the core benefit of such an agreement and is the most popular reason for establishing a trust. A life insurance trust is designed to be permanent and irrevocable. While you may decant, transfer, or agree on a non-judicial settlement to alter a trust, it is a difficult process that can put your assets at risk. For example, if you decant a trust, reducing beneficial interests, the trust will be closely examined and could be deemed invalid.
Benefits of an Irrevocable Life Insurance Trust (ILIT)
Setting up an ILIT is a smart financial planning decision, particularly if you have significant tax liabilities and sizeable net worth. Apart from minimizing estate taxes, irrevocable trusts offer several other benefits:
Avoids probate
Probate is the legal proceeding surrounding the distribution of assets according to someone’s will. It can be a lengthy process, especially when dealing with large estates. On average, probate takes anywhere from nine months to two years. Since wills can be contested, the probate period can last even longer.
An insurance trust allows the trustee and beneficiaries to avoid probate. Your trustee can begin allocating your assets immediately, as arranged. This is particularly important if a beneficiary is a dependent with special needs or health issues. Avoiding the probate process also helps keep your affairs private.
Gift taxes exemption
Any assets received by the beneficiaries are categorized as gifts from you, the grantor. Gift tax applies for the transfer of products and services in this scenario. However, the trustee can ensure the gifts are kept tax-free by drafting a Crummey letter. This letter gives beneficiaries a 30-day window to withdraw a portion of the insurance proceeds.
Protects recipients of government aid
If a beneficiary is a recipient of government aid, such as welfare or Medicaid, a life insurance trust can help ensure they continue to receive these funds. While receiving a significant sum of money could, in some cases, affect your government aid, an ILIT doesn’t affect entitlement to such benefits.
You and your trustee can create a distribution structure that won’t affect their eligibility, allowing them to access the funds and retain their government financial aid.
Control over asset distribution
One of the most significant advantages of an ILIT is the increased control over distributing the proceeds of your insurance policy. The trustee has the legal power to determine how the assets are paid.
The grantor and trustee typically agree on the payment distribution plans when setting up the trust. The trustee bears financial responsibility to the beneficiaries, so they are not at liberty to go against the distribution plans previously agreed upon.
Financial discretion is useful when dealing with young beneficiaries who may not be in a position to manage their portion of the insurance benefit responsibly. The trustee can agree to distribute insurance allocations when beneficiaries reach a certain age or achieve particular milestones. For example, the trustee may distribute a specified amount when a beneficiary graduates from college or has their first child.
Although a relative or close friend is often designated as the trustee, this isn’t always the case. Grantors often list a financial advisor as their trustee because of their specialist knowledge and skills to oversee complex insurance policies. Fiduciaries are also bound by ethical and industry standards, helping to protect your beneficiaries.
Helps beneficiaries pay estate taxes and debts
In addition to minimizing estate taxes, insurance trusts can afford your beneficiaries more financial freedom to pay off debt and mandatory estate taxes. Rather than absorbing the insurance policy as a taxable asset, your beneficiaries profit from reduced taxes and a full insurance payout. The death benefit may then be allocated to cover the estate tax, reducing the financial burden on your family.
Plan Your Estate Responsibly With Finance is us
Life insurance trusts are complex agreements that involve significant time, paperwork, and initial upfront costs. However, the tax savings and increased control over asset distribution can be hugely beneficial to your family’s future.
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Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.
