Life insurance is a helpful estate planning tool, as the death benefits are generally federal income tax free to the recipients, which might be your spouse, children or even a favorite charity. And under certain circumstances, combining a policy with a trust can enable you to reduce your tax exposure or make sure your funds are going to the right place.
Use life insurance to provide for a loved one
There are a few scenarios when it might be problematic for someone to receive a life insurance payout. Many states won't give life insurance proceeds directly to a minor child, for instance. If you have heirs with special needs, or with alcohol or drug or gambling problems, or who might have a creditor problem at any point, leaving them money can create more problems than it solves. In these cases, making a trust your beneficiary—and having the trust manage funds for your loved one—can be a better solution.
This scenario is also helpful if you want some say in how your life insurance proceeds are spent or distributed. Once you designate a trust as your policy's beneficiary, your trustee is tasked with honoring any directives you put into your trust. An estate planner can create a trust for you for this purpose.
Use life insurance to reduce taxes
When you own a life insurance policy, the benefit is included in your taxable estate. This isn't an issue if your estate falls under the estate tax exemption—$5.6 million per individual in 2018. But that threshold may be easier to hit than you think.
Consider the individual who lives in an area with high home values, who owns a business and who has a healthy retirement nest egg. If that person also has a life insurance policy worth $1 million to $2 million, they might be looking at estate taxes. That's something to consider, because the federal tax can be as high as 40% of your taxable assets.
This is where a trust can come in. Because a trust is a legal entity unto itself, it can own a life insurance policy in your stead. That way the policy's proceeds won't be included in your taxable estate.
Grantors, trustees and beneficiaries
To make this work, you must create the trust, which makes you the grantor. You will then select a trustee to manage the trust—and this can't be you. You might select a spouse or an adult child for this task, but many people choose a corporate trustee for such a role. The trustee would then buy the insurance policy, with you as the insured, and make the premium payments.
The trustee would also select the beneficiary of the policy, which could be anyone but is often the trust itself. If the trust is the beneficiary of the policy, you will have some say in what happens to the benefit once it's paid out. For instance, it could be used to cover estate taxes or other expenses that pop up after you die. It could provide for a surviving spouse without being included in his or her taxable estate. And it avoids any risks that come with selecting a beneficiary who might die or become incapacitated before the payout.
A gift for premiums
Because you aren't the owner of this policy, you can't make the premium payments yourself. But you can send tax-free gifts to any beneficiary of your trust, and they can then use that money to pay the policy's premiums. You're able to gift $15,000 per year to any individual without triggering any gift taxes starting 2018. As a couple, you can give $30,000 to a single beneficiary annually.
There's one important thing to note: If you're transferring existing policies to a trust, rather than having the trust 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 a part of your estate.