When it comes to developing life insurance policies, one of the most essential yet challenging parts of this process is determining who your life insurance beneficiaries should be and how to organize them.
If you are unsure who to name as a beneficiary of your life insurance policy, you might consider a trust. However, you will first need to understand what this means, in what cases a trust is the best option, as well as general benefits and mistakes to avoid.
WHAT IS A TRUST
A trust is an entity in which you can place your assets to be used by you or a future beneficiary, or beneficiaries.
The trust can be the owner, or the named beneficiary of the life insurance policy as well. In the case that the trust is named as the beneficiary of a life insurance policy, the life insurance death benefit will be paid, in lump sum, to that trust and distributed accordingly as established in the trust.
A trust can have a bank account opened by the executor of the trust, otherwise known as the trustee.
Overall, a trust, for the sake of life insurance, should be made up of the policy owner, or grantor, the beneficiary who will receive the trust assets following your death, and the trustee who manages the trust.
Here’s more regarding the difference between a policy owner and a beneficiary: read more
This will be officially established on your trust document, which should outline how the trust works in addition to the people designated for each of these roles.
It’s also important to consider the various types of trusts. You may list either an irrevocable living trust or a revocable living trust as your life insurance beneficiary, but what does that mean?
REVOCABLE VS IRREVOCABLE
The primary difference between an irrevocable life insurance trust and a revocable life insurance trust comes down to the flexibility. A revocable trust essentially means that you can change or revoke the trust.
On the other hand, an irrevocable trust can not be modified or canceled in most cases.
More on the differences here: read more
When it comes to choosing one or the other, there are various pros and cons to be considered.
Aside from the flexibility aspect of using a revocable trust, there are also other benefits that may come with it. For example, when using revocable trusts, probate can often be avoided. Probate is the legal process in which your policy is authenticated and the distribution of the assets left behind after your death are established.
This process, however, can be very time-consuming and expensive. This means that avoiding probate saves time, money, and stress as assets bypass the process and are distributed without involving the court system.
Another benefit is that this form of trust can provide protection in the case of incapacitation, meaning you can no longer care for yourself or manage your assets. In this case, the trustee can take over and manage these assets for you.
Overall, a revocable trust is a great option if you know you may potentially need to make changes and want to avoid issues such as probate.
Revocable trusts do have some tax implications. First, revocable trusts are part of your estate, your taxable estate, which means they could be subject to federal estate taxes after your death. Your estate would most likely need to be worth upwards of 12 million dollars for the estate tax to come into play.
Another downside of utilizing this trust could be the lack of protection against creditors, which you’re often more protected against when using an irrevocable trust. In this case, your assets are not necessarily safe or beyond creditors’ reach.
You may consider an irrevocable trust if asset protection and tax benefits are important to you.
Creditors have a difficult time getting to any life insurance proceeds, unless they are listed for the sake of collateral because of a bank loan.
So what are the benefits of utilizing an irrevocable trust?
As previously stated, revocable trusts don’t protect assets from credits; however, the life insurance payout will most likely be protected in the case of having an irrevocable trust named to your policy. This means the entirety of your payout will go to the beneficiaries of the trust, and creditors will be unable to collect on your assets. It is also beneficial when managing taxes, or, more specifically estate tax obligations. Since assets are technically owned by the trust in this case, it’s more likely that you can avoid these obligations.
When considering which of these may be best for you to appoint to your life insurance policy, consider the following factors:
- Control over assets
- Flexibility/Ability to modify policy
- Privacy of transfer/Probate process
- Tax obligations
You may want to utilize a revocable trust when you want more control and flexibility over your assets and policy with the ability to make changes, as well as avoid the legal process of probate in handling your assets and payout.
You may prefer using an irrevocable trust when you want to protect your assets from creditors and manage taxes with more ease.
SHOULD I NAME A TRUST AS MY BENEFICIARY?
After deciding the type of trust that is most beneficial to you, you have the ability to name this trust as your life insurance policy’s primary or contingent beneficiary. Before making this decision, though, it’s important to determine whether you actually need to appoint a trust as the beneficiary over others, such as your spouse, young children, or other close family members.
Let’s consider the pros and cons of listing a trust as your life insurance beneficiary, and whether this move is best for your own policy.
THE PROS OF A TRUST AS MY BENEFICIARY
Naming a trust as a beneficiary can be especially helpful for families with minor children and/or family members with special needs. You can still control how the assets are distributed, but the trust simply receives the life insurance payout and, in turn, directs those proceeds to these family members.
For minor children, you can adjust your trust guidelines to cover the costs of their care while under a legal guardian, and you may then also create a stipulation that provides them with the remainder of the payout once they turn 18 or at any age thereafter.
WARNING: Be very careful when wanting to name young children as your beneficiaries. No funds will be released to anyone under the age of 18. You will need an executer to handle the transfer of those funds when minor children turn of age. Read more
Having a trust as your life insurance beneficiary ensures you are able to care for your children after passing, especially when minor children should not be named as beneficiaries on your policy.
Another benefit of utilizing a trust as your life insurance beneficiary is that it helps you sidestep issues like probate. Avoiding probate itself saves a vast amount of time and money for whoever you designate to receive your proceeds.
During this legal process, legal fees, outstanding debts and taxes, and other expenses may be taken out of the payout you wanted to go to your children, spouse, or other family members. Being able to avoid this can ease your worries and ensure that your family doesn’t have to deal with it, also allowing them to receive the entirety of the proceeds from your policy.
THE CONS OF A TRUST AS MY BENEFICIARY
While it may be beneficial for your life insurance beneficiary to be a trust, there are also some downsides to consider before committing to this decision.
For starters, establishing a trust can be an expensive task. You must be willing to commit both the time and money to this process to reap the benefits. Not only will there be expenses you need to cover, including those needed to set up the documentation, transfer ownership, legal fees, and more, there will also need to be time dedicated to the task.
It may feel like there isn’t enough time for it, but consider the time and money you are putting forth now is ultimately saving your children or other family members from doing the same in the future.
You should also consider your policy in terms of taxes. Let’s say you name your spouse as your primary beneficiary. When it comes to federal tax, this beneficiary would most likely receive the life insurance proceeds that are income tax-free and estate tax-free.
However, when trusts are beneficiary designations and proceeds of a life insurance policy are paid to them, the payout can then be subjected to estate tax. They may also not qualify for inheritance tax exemption depending on the state. Having a trust appointed as your life insurance beneficiary may lead to higher tax being owed and the inability to avoid some taxes overall.
Deciding your beneficiary designations on a life insurance policy can be a daunting task. You may find it challenging to decide who is best to appoint to the roles. Aside from considering the pros and cons of naming a trust as your beneficiary, also look to the numerous resources available to you to assist you through the process.
Understanding whether a trust beneficiary is right for you can be made easier with the help of a financial planner and legal advice from an estate planning attorney. They can assess your specific situation and aid you in developing a plan for your life insurance policy.
The problems with not listing a beneficiary: read more
This process can be very time-consuming, confusing, and challenging, so using these resources will ensure that you have a plan and are confident in what you have established for the future of your family.