Life insurance policies exist to provide an additional financial safety net for our loved ones in the case of an untimely death or serious illness. This is especially true for primary earners or breadwinners, who may be worried about what might happen to their family if they were to disappear.
Through a life insurance policy, these primary earners can ensure that, if anything drastic were to happen, their family would have a sizeable financial cushion to help them get back on their feet and figure out a way to move forward through life, pay for debts and education expenses, cover funeral costs, protect, and keep your business afloat during a transition period, and more.
But how do life insurance payouts figure into estate plans? Unlike life insurance policies, most of what we own is meant to be enjoyed while we are alive – and when we die, it must be distributed to someone else. Wills and trusts are two common forms of estate planning that help a person leave behind instructions on who should get what asset or property after death.
Without an estate plan, everything left behind after you die automatically distributed according to your state’s intestate succession rules and probate code. Taking control of how and when you bequeath an inheritance can help you ensure that your family can make the best of what you leave behind.
However, life insurance trusts usually have their own beneficiaries and do not pass through the “probatable estate.” This has its advantages and drawbacks, based on the value of what you currently own (your estate) and the size of your life insurance policy.
How the Probate Process Works
When you die, everything you leave behind becomes part of your estate. Unless it has a direct designated beneficiary, it will likely pass through a probate process before it can be distributed to one of your heirs, whether as per your will or as per the state’s intestate succession.
This probate process is overseen by your local probate court and will be managed by a representative of your estate – either someone you can appoint as such in life or someone chosen by the court after your death.
The probate process is lengthy and involves everything from legitimizing the will to evaluating the estate, paying off final debts, and distributing assets and property. Life insurance policies are usually one of the few things that are automatically exempt from probate because they are immediately passed to a designated loved one instead.
Other examples include retirement accounts with designated beneficiaries, bank accounts with beneficiaries, and homes that have been designated transfer-upon-death. However, all these assets and properties continue to count towards your estate’s total value, which can have a sizeable impact on the potential tax bill of your death.
While the current federal estate tax exemption limit remains quite high, there are good chances that it will be lowered to its pre-Trump levels (approximately half of what it is now), and depending on the size of your life insurance policy, a portion of your estate may end up being eligible for estate taxes after your death. This is where trusts come into play.
What Is a Trust?
A trust is a legal entity created through a trust document by a trustor and managed by a trustee for the sake of a beneficiary. Trusts can hold property in-trust and can be written to separate all property and assets held within from the original grantor if the trust is made irrevocable.
This entails that if a grantor creates a trust they cannot unmake, they relinquish control over certain assets and properties but ensure that these do not count towards their taxable estate, nor can they be touched by creditors.
This allows you to effectively fund your life insurance policy into a trust that will hold said policy and its contents for the benefit of one or more designated beneficiaries, without having the payout of the policy count towards the total value of your estate.
Furthermore, the policy’s beneficiary becomes the trust itself, so once you die or are completely incapacitated, the payout is funded into the trust, and the trustee can manage the funds as per your wishes before death. This is called an irrevocable life insurance trust (ILIT).
Benefits of an Irrevocable Life Insurance Trust (ILIT)
There are many significant benefits to an irrevocable life insurance trust, aside from tax benefits and asset protection. An irrevocable life insurance trust:
- Gives you greater control over how the contents of the life insurance policy are paid out to your family.
- Can help you minimize the inheritance and income tax burden on your family.
- Allows you to grow and invest part of the payout over the course of your heir’s childhood until they are ready to inherit their portion of the trust.
- And naturally, an irrevocable life insurance trust also skips probate.
Trusts can be used to fund other portions of your estate to reduce your probatable estate. Revocable trusts, for example, grant you much greater control over the contents of your trust while you are alive, at the cost of counting towards your taxable estate. For tax purposes, anything held in a revocable trust you set up is still your property while you are alive and becomes part of your estate when you die.
However, a revocable trust gets to skip probate and can be held and managed by a trustee or immediately distributed upon your death or incapacity, depending on how the trust agreement was written. Trusts are often the perfect tool for crafting a flexible estate plan that best complements your needs and wishes, especially if you seek reassurance and financial security for your family. Work with an estate planning professional today to draft an estate plan that suits you.