How to Supercharge 4 Types of Trusts with Life Insurance

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For the majority of you who own life insurance, it's perfectly fine to list individuals such as your spouse or children as beneficiaries on your life insurance policy.

But, there are a number of situations when it might be better to set up a trust and name it as the beneficiary of any life insurance policies you own instead. This could be especially important if you:
  • have a large estate;
  • your beneficiaries can't manage money;
  • you wish to protect their inheritance from creditors;
  • you have special needs children.
Depending on the type of trust, there are many benefits which can be found for those in a variety of unusual, or more complex financial and personal situations. There are simple trusts which can be established for the average person and more complex trusts for those with large estates.

Although there are many different types of trusts, we are going to focus on the advantages of using the following 4 types of trusts in conjunction with life insurance:
  • Irrevocable Life Insurance Trust, or ILIT
  • Simple Living Trust
  • Special Needs Trust
  • Spendthrift Trust
Let's take a look at these 4 different trusts and how you can enhance them by naming them as beneficiary to your life insurance policy.

Irrevocable Life Insurance Trust

An ILIT is used to irrevocably purchase life insurance on the life of the insured (typically the grantor of the trust) and also to receive the death benefit.

Since the ILIT applies for the coverage, pays the premiums, and receives the death benefit when the insured dies, any life insurance proceeds paid to the trust are effectively removed from the insured's estate.

In the past, the ILIT was typically used by families who had estates valued in the $2 to $7 million range or higher. This was especially important in the early 2000's when the estate tax exemption was lower, such as $1 million a person in 2002 or $3.5 million in 2009. The ILIT wasn't only used to provide liquid funds to pay the estate tax bill, but also to ensure that life insurance proceeds paid to the trust would not be included in the insured's taxable estate, compounding their estate tax problem.

However, since congress passed the American Taxpayer Relief Act of 2013, effectively raising the estate tax exemption amount to over $5 million a person ($5.43 million in 2015, $10.86 million for a married couple), very few estates now owe federal estate taxes.

In fact, estimates that 99.5 percent of all estates will not owe any federal gift/estate tax. Therefore, using the irrevocable life insurance trust strictly for estate tax avoidance has become exceedingly less common.

But that's not the end of the story with ILIT's.

Rebecca Neale, attorney at Fort Point Legal, says that some people are neglecting to plan for another important type of death tax.

"Many people make the mistake of only considering federal estate tax. Since the federal estate tax exemption is $5.43 million per person, they might erroneously believe they won't owe any estate taxes.

However, many states also impose an estate tax, and some of them have much lower exemption amounts than the federal level. In other words, some peoples' estates that won't owe federal estate taxes may owe state estate tax. For example, in Massachusetts, the exemption amount is only $1 million, with tax rates as high as 16 percent."

A knowledgeable estate attorney will remind you that just because you don't currently exceed the $5.43 million estate exemption, an ILIT could still be important for individuals with growing estates.

Such is the case for the clients of Richard Trimber, an attorney at General Counsel. Trimber, who specializes in helping business owners and executives, says the ILIT is still an important planning tool for his clients, and frequently uses them in conjunction with buy-sell agreements.

Trimber explains:

"In many cases, when the life insurance policy is owned in the name of the owners or the business, the decedent's estate may owe estate taxes on the value of the business. However, when the policy is owned outside of the decedent's estate in an ILIT, and with a properly structured buy-sell agreement, the assets owned by the ILIT will not be considered part of the estate for inheritance/estate tax purposes -- meaning the heirs won't have to pay estate or inheritance taxes on them."

Simple Living Trust

You can also set up what is known as a "simple living trust" and have the choice of choosing between either a "revocable" trust which means that you can change the terms of the trust at any time, or an "irrevocable trust" which means that you can't change the terms at any time.

In a simple living trust, you transfer the ownership of your assets out of your name and into the name of the trust. You no longer own the assets that you have transferred but you can still use them as the trust specifies.

Besides the general benefits that any trust provides, such as avoiding probate and keeping your distribution wishes private, combining a living trust with life insurance can provide valuable asset protection for your loved ones.

Tina Dockery from the Dockery Law Group, specializes in wealth transfer planning and beneficiary planning.

"Estate planning is more than just transferring wealth; it's also about protecting your loved ones," Dockery says.

And while many people associate advanced estate planning strategies with the irrevocable life insurance trust, Dockery says a simple revocable living trust can also provide valuable benefits to families.

"One underrated estate planning technique is to funnel your life insurance into a protected continuing trust for your children or other beneficiaries," says Dockery. "If your life insurance beneficiary form designates your trust as the primary beneficiary, at your death or upon the death of your surviving spouse, your life insurance proceeds can be asset protected for your children from creditors, predators and future divorcing spouses in a continuing trust that can spring from specific language in your revocable living trust."

Special Needs Trust

According to Cornell University, disability statistics for children from age 5 to 15 reveal that 5.3 percent or approximately 2.93 million children have 1 or more disabilities. Many of these children are special needs children which require special care and long term planning for their continued quality of life.

Many parents have taken steps to protect and financially care for these special needs children, such as buying a life insurance policy. But, that might not be the best route to take. The first problem with this is that no life insurer will issue the life insurance proceeds to a beneficiary who is a minor. And, the second problem that arises when naming the child as beneficiary could end up in having the special needs child denied from accessing vital government services and benefits.

Under federal law, any inheritance which is greater than $2,000 may disqualify an individual from federal and many state assistance programs. One example is the Supplemental Security Income, or SSI, which could be reduced or canceled for up to three years for any child that is in receipt of either an inheritance or life insurance benefit.

By properly setting up a "Special Needs Trust" funded by life insurance, you can both provide financial protection for special needs children and keep them eligible for government assistance. When properly set up, the special needs trust doesn't allow the recipient to own any of the estate's assets. This allows them to be eligible for other forms of government assistance. Yet, the trust can still be financially structured to provide for vital expenses such as transportation, home health care, rehab, medical and dental care not covered by Medicaid or Medicare, along with education.

One of the problems with these trusts, though, is parents don't typically have the cash to fund them properly. That's where life insurance steps up and fills the gap. For pennies on the dollar, you can fund the trust with your life insurance policy instead of a large cash deposit.

Spendthrift Trust

If you have a large life insurance policy (note: this varies for many but typically anything over a $1 million policy could qualify), and aren't sure you want your beneficiary receiving the entire amount in lump sum, you may want to consider naming a trust your beneficiary with a spendthrift clause. A spendthrift trust is specifically designed for a recipient who is considered as being a financial liability or unable to responsibly manage their financial affairs, such as if they have a gambling addiction. The trust is set up to be managed by an appropriate independent trustee.

The provisions in the trust will designate that the trustee will pay a set amount of money, such as life insurance proceeds, to the named recipient. How much and when the payments are dispersed will be specified by the terms outlined in the trust.

In this scenario, the recipient will only receive the amount designated by the trust. This could be for a specific number of years or for the lifespan of the recipient. This type of trust also contains some asset protection benefits. Creditors cannot claim any funds until the recipient has actually received the money. Many states have what is known as a doctrine of "surplus income." This means that a creditor can only attach any trust income received which exceeds any amount above that which is needed to support the recipient.

Some states have established a specified percentage amount of trust proceeds that cannot be attached. If the cost of setting up a trust with spendthrift provisions is prohibitive, you might consider buying a term life insurance policy from a carrier who will allow you to elect an annuity payment for your beneficiary rather than lump sum. While your beneficiary won't enjoy the asset protection of the trust in this scenario, at least you can accomplish the goal of spreading out his payments over a set period of years. The insurance companies also give you a break on the cost of insurance if you elect an annuity payout.

Regardless of what type of trust you decide upon it is vital that you follow all the appropriate legal protocols in the state you reside. Some trusts are much more complicated to set up, but any form of trust should be established by an experienced estate attorney.
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