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3 Ways Life Insurance and Trusts Work Together

Mar 18, 2020 4 min read Bana Jobe

Key Takeaways

  • Naming a trust as a beneficiary can be a smart estate planning move.
  • Trusts can reduce your tax burden, help manage funds and ensure your directives are honored.
  • An estate planner can counsel you on what's best for your situation and help create a trust that meets your needs.

 

You might consider life insurance and trusts as separate pieces of the estate planning puzzle — right along with a will, advance directives and powers of attorney.

But in reality, there's a lot of value in optimizing your life insurance policy and testamentary trust so that they work in tandem, not just in parallel. In fact, treating them as a pair could potentially help you reduce your tax exposure, route your funds to the right place and ensure your wishes get carried out.

But how? Here are three ways that life insurance and trusts can help you make the most of your options as you develop your estate plan.

 

 

1. A trust may be able to reduce the tax burden of your life insurance benefit.

When you own a life insurance policy, the death benefit is included in the value of your taxable estate. Luckily, this isn't an issue if your estate falls under the estate tax exemption ($11.58 million Opens in new window per individual in 2020).

However, if you live in an area with high home values, own a business or maintain healthy retirement savings — and then couple that estate value with a life insurance benefit worth a few million dollars — you might face estate taxes. For some people, the tax rate could be as high as 40% Opens in new window. In these situations, a trust can be a very helpful tool. As a legal entity, it can own a life insurance policy in your place and prevent the policy's proceeds from being included in your taxable estate.

 

2. A trust can direct insurance payouts to the right place.

In scenarios when it might be problematic for someone to directly receive a life insurance check — like if the beneficiary is a minor or has an intellectual disability — the trust provides a legal framework for the proper management of those funds. When you name the trust as your beneficiary, the trustee (the person or entity you name to manage the trust) handles the funds on behalf of the beneficiaries.

 

3. A trust can help ensure your wishes are carried out.

A trust is also helpful if you want a say in how and when your life insurance proceeds are spent or distributed. Once you designate a trust as your policy's beneficiary, your trustee must honor any directives in your trust; this includes distributions to charities or use of the insurance proceeds to cover estate taxes or other expenses.

Another directive could provide for a surviving spouse without being included in their taxable estate. Additionally, naming the trust as the beneficiary avoids the risks that come with selecting a beneficiary who might die or become incapacitated before the payout.

 

How to establish a life insurance-trust combo

First, meet with an attorney to help develop an estate plan. As part of that process, you'll create a trust, which makes you the grantor. You'll also select a trustee to manage the trust; for a testamentary trust, this can't be you. You may select a spouse or an adult child as the trustee, or you can select a corporate trustee, such as a bank. Some people prefer to elect a corporate trustee because they're an unbiased party.

Depending on your attorney's recommendations, the trustee should then buy an insurance policy, with you as the insured and the trust as the beneficiary. Because you won't be the owner of the policy, you can't make the premium payments yourself — the trustee must do that. However, you may be able to send tax-free gifts to a beneficiary of your trust, who can then use that money to pay the policy's premiums. For most people, this means the ability to gift $15,000 per year Opens in new window to a single beneficiary.

There's one important thing to note: If you transfer existing policies to a trust rather than have the trustee purchase a new policy, there's a three-year period before the transfer becomes valid. If you die before then, the IRS will consider those life insurance benefits to be part of your estate.

 

What you can do next

Talk to your financial planner and attorney about using life insurance in tandem with a testamentary trust to accomplish your estate planning goals. Get an early start preparing for these conversations by taking inventory of your current estate value and learning about the different types of life insurance.

Prudential Financial, its affiliates, and its financial professionals do not render tax or legal advice. Please consult your tax and legal advisors for advice concerning your circumstances.

 

Footnotes

Bana Jobe is an Austin-based health writer and editor with more than a decade of content experience for brands, agencies and digital media. She loves turning complex concepts into empowering stories.

 

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