A life insurance policy can be a flexible financial tool meant to help give your spouse, children, or other beneficiaries the financial means with which to help themselves cover costs after your death. Sometimes, life insurance policies are built into an estate plan explicitly to cover state and/or federal estate taxes when all other options have been exhausted.
Because life insurance policies immediately pay out to beneficiaries after the principal’s death, they bypass the probate process. They additionally don’t count towards the beneficiary’s income (though they do, on their own, count towards the estate’s total value). This makes a life insurance policy a convenient way to setup an additional financial windfall for a loved one without further adding to the stress of probate.
But life insurance policies are simple, typically providing a single lump sum payout upon the principal’s death. This can be a burden to a financially inexperienced adult, or even a minor, who cannot yet make use of their inheritance. Without any further planning, a court will usually step in to ensure that the money is kept safe until the beneficiary is of age.
Furthermore, if you are planning to use a life insurance policy to help your loved ones cover estate taxes, simply naming a beneficiary and bypassing probate does not separate a life insurance policy from your estate. It may end up inflating your estate further, thereby causing a greater tax burden. The solution to both of these issues is to manage your life insurance policy through an irrevocable trust, called a life insurance trust.
A life insurance trust is a type of irrevocable trust meant to create a clear boundary between your estate and your life insurance policy. This legal instrument lets you:
The current exemption limit on the federal estate tax is $11.58 million. If a life insurance policy is likely to cause your estate’s total value to exceed that limit, your estate may be liable for a hefty tax. It is also worth noting that the exemption limit may change in the coming years, so amending your estate plan regularly considering any tax changes is important.
Furthermore, state estate tax exemption limits are much smaller than the current federal estate tax exemption limit. Depending on where you live (some states do not have state estate taxes), your estate’s current value may trigger estate taxes. Naming another person as the owner of a policy on your life may keep it out of your estate, but it is effectively like playing a game of hot potato.
If they happen to die first, the cash value of the policy will instead be a part of their taxable estate. By controlling a life insurance policy via an irrevocable trust, you retain some level of control, but avoid a level of ownership that would contribute to your estate’s value.
Like any trust, there are three basic roles to be filled in the setup of a life insurance trust: the grantor, the trustee, and the beneficiary. While some trusts are designed to let you fill all three roles, these three roles must be explicitly separate in a life insurance trust. This is because life insurance policies are paid out when the principal dies, so you (the grantor) cannot be your own beneficiary.
Secondly, being your own trustee also defeats the point of the trust, as you are no longer separating yourself (and thus your estate) from the life insurance policy. A life insurance trust is only valid if you drop the right to revoke the trust (making it irrevocable) and do not name yourself as trustee. Upon setting up a life insurance trust, you effectively leave the management and distribution of the trust within the trustee’s hands.
Careful language is important here, as a well-crafted trust document should explain in detail what you want to have done with your life insurance policy, and how your trustee should best handle the distribution of the policy once you die. Trustees hold a fiduciary duty to your best interests and the best interests of the beneficiaries attached to the trust, but without clear directions, that duty can potentially be interpreted in many ways.
You could, for example, detail that the contents of the policy are to be used to pay for your child’s college tuition fees and assorted expenses, or to provide them with a sizeable windfall when they start their own venture. Beneficiaries to a life insurance trust do not need to pay income taxes on the contents of the policy.
When drafted properly by a professional, a life insurance trust can store and pay out its cash value without triggering any gift taxes through the use of annual Crummey letters. These are letters that effectively inform the beneficiaries of the trust that they are free to withdraw the amount gifted to the trust, which would make it a tax-free gift in the eyes of the IRS, as beneficiaries reserve the right to take the amount in the short-term.
The hope is, however, that they do not. If documented diligently and sent out year after year, these letters can prove that the contents of the life insurance trust can be distributed to beneficiaries without worrying about any gift taxes. Consult a tax and/or estate planning professional for more information and specific advice on setting up a life insurance trust without the need to file a gift tax return.
Life insurance policies can help your family receive more money when you die, but they can inflate the value of your estate, or potentially burden a young beneficiary if you happen to pass away earlier than expected. Life insurance trusts provide you with greater control over how and when your policy’s contents should be used, without contributing to your estate’s total value, or anyone else’s. However, these trusts should be written carefully to avoid any issues caused by oversight or lack of detail.
Founded in 1975 by L. Rob Werner and serving California for over 48 years, our dedicated attorneys are available for clients, friends, and family members to receive the legal help they need and deserve. You can trust in our experience and reputation to help navigate you through your unique legal matters.
Whether you need help creating a living trust or navigating probate, our living trust law firm's compassionate team of estate planning lawyers and probate lawyers are here to help you and ready to answer your questions.
Our goal is to make your case as easy as possible for you. Hiring a lawyer can be a daunting task, but it doesn’t have to be. From the moment you contact our firm, through the final resolution of your case, our goal is to make the process easy and understandable. We cannot change the fact that probate is a long and complicated process, but through our Werner Law Firm Difference, we strive to go out of our way to keep you informed of your case through every step of the way. We are constantly refining our processes and procedures for a more streamlined and calm client experience. Our goal is to have you feel like a burden was lifted from your shoulders, and that we made the whole process an easy one
If you're dealing with a legal matter, we urge you to schedule a free initial appointment today and join the many satisfied clients who have contacted Werner Law Firm.
23 Corporate Plaza Dr., Suite 150
Newport Beach, California 92660