The Estate Planner's Secret Weapon to Fight Against Taxes: Life Insurance Trusts
People take out life insurance policies so that their loved ones are protected if they die. Personally, I have several policies of varying types. The goal is to protect my wife and my children from the loss of my income if I pass away. Without my income, they wouldn’t be able to pay for my mortgage or the kids’ college. So, I have some high-value policies in place, in case the worst should happen. Having a policy is a great “Step 1” but then what? Do the policies create any problems? You might not hear this from your life insurance broker, but yes, the policies can create problems, especially with estate taxes.
There is a straightforward answer to this problem: Life insurance trusts. These trusts cover the distribution of your policy death benefits after you’re gone, and they can help you save on estate taxes. In fact, a proper life insurance trust can save you SIX FIGURES OR MORE in estate taxes if you have a large life insurance policy! These types of trusts are irrevocable, so they cannot be changed after your passing, which means that no one can alter your wishes after your death.
Keep reading to see how these trusts can help you. Here's a hint: If you have a large life insurance policy and your estate planning lawyer didn't discuss this with you, get a new estate planning lawyer.
First things first: What is a life insurance trust?
A life insurance trust, often called an "ILIT", is a trust that holds your life insurance policy. When you die, the life insurance policy pays out the proceeds according to the trust terms that you choose. If you have young children, you can spread the disbursements over time, rather than lump-sum, which is a big plus. If you’re divorced and have young kids, you can put control of the funds in the hands of a trustee of your choosing, as opposed to your ex. But the biggest advantage is the estate tax savings they provide.
How can a life insurance trust help you?
There are several advantages to a life insurance trust, including:
- Estate Tax Protection
- Control over the use of the money
- Protection from Creditors
- Probate Avoidance and Asset Protection
Let's take a closer look at each of these benefits.
Estate Tax Protection
One of the most important benefits of a life insurance trust is that it protects your beneficiaries from estate taxes. Estate taxes can eat away at your family's inheritance in a BIG way, especially in Massachusetts! Having a life insurance trust in place can ensure that your loved ones receive the full benefit of your life insurance policy. Without the trust, the policy could end up being used to pay estate taxes.
A life insurance trust can remove the value of life insurance proceeds from your taxable estate. Why is this important? Because Massachusetts has an incredibly low threshold for estate taxes. Most people don't realize that life insurance proceeds become part of your taxable estate when you die. That's exactly how the government wants it. While the insurance payout is not income taxable, it is estate taxable! The value of the death benefit is added to your taxable estate. In Massachusetts, the policy can put you over the limit very easily because it counts toward the $1 Million estate tax threshold and can result in HUGE estate taxes. For those of us with young children and large life insurance policies to protect them, our policies alone can put us over the estate tax limit BEFORE OUR OTHER ASSETS ARE EVEN LOOKED AT! When we add the life insurance death benefit to the value of your other assets, and the sum is over $1 Million, your beneficiaries now must pay Massachusetts estate tax (and sometimes federal estate tax too).
That means you might be what we call an "Estate Tax Millionaire"! You might not have over $1 Million while you're alive, but when you die, the life insurance proceeds are added to your other assets to determine your taxable estate, and BOOM! you're a millionaire, albeit a dead one. Congratulations, your beneficiaries now must pay estate tax.
Control over the use of the Money
When you leave a large financial asset like life insurance to your loved ones, there is no guarantee that it will be used for their benefit. A guardian for your children could use the money with no oversight whatsoever. With a life insurance trust, you can outline exactly how and when the funds should be distributed to ensure that they get used as intended. Maybe you want to space out the gifts instead of lump-sum. Maybe you want to shield it from divorce. A life insurance trust can do both.
A large death benefit might be too much for a young kid of 18 to handle. With the trust, you can disburse the amount over time, or as a lump sum, but in the manner of your choosing. You make the rules so that the money is used for things like education, living expenses, and getting a head start in life, rather than being wasted by kids that just don’t know any better.
Protection from creditors
If you have any outstanding debts at the time of your death, a life insurance trust can be set up to protect the proceeds from claims by your creditors. This means that your loved ones will be able to receive the money without having to worry about paying off any outstanding debts you (or they) may have.
Probate Avoidance and Asset protection
Unlike cash assets, life insurance benefits are not subject to probate, if you have living beneficiaries named on your policy at the time of your passing or have a life insurance trust. The policy pays proceeds directly to your beneficiaries (or the trust) outside of the probate court system. The trust keeps the policy out of probate, allowing the funds to be available right away. It can also prevent disputes over who should be entitled to the proceeds, ensuring that your loved ones receive their inheritance quickly and easily after you pass away.
How to set up a life insurance trust
When setting up a life insurance trust, there are a few factors to consider:
- The trust must be created during your lifetime and the life insurance policy must be transferred into the trust while you are still alive – we can’t give a directive in our Wills to do it after you’re gone. This means that you will need to make sure that the life insurance policy is updated with the new trust information. A brand-new policy is protected immediately, while an existing policy is subject to a waiting period.
- The trust must be irrevocable - once it is set up, the trust cannot be changed or revoked. This guarantees that your loved ones will receive the benefits of the life insurance policy after you die in the manner of your choosing, and your wishes can’t be changed.
- You will need to name a trustee of the trust, and the trustee can’t be you. It can be a spouse, another family member, or anyone else of your choosing. The trustee’s job is to manage and distribute the funds from the life insurance policy according to the terms of the trust. The trustee must be someone you trust to make decisions for your family, and they are required to honor the trust terms as to how the life insurance proceeds should be used. It’s important to name a backup trustee as well in case your primary trustee predeceases you or is unable to serve as trustee.
When setting up a life insurance trust, it is important to work with an experienced estate planning attorney who can go over your options with you. An experienced attorney will be able to set up the trust in a way that meets your specific needs. They will be able to help you understand the benefits of a life insurance trust and determine if it's right for you.
Some Final details on life insurance trusts
Not only do life insurance trusts provide peace of mind that your loved ones will be financially secure, but they also offer protection from Federal and Massachusetts estate taxes, as well as probate avoidance. The return on investment for life insurance trusts is clear - they are an essential tool to avoid estate taxes for anyone with a life insurance policy and looking to protect their loved ones after they are gone.
This is an expert-level technique and should not be done by attorneys who “dabble” in estate planning. Do it wrong, and it’s all for nothing. It is important to work with an experienced attorney who specializes in the field.
If you have any questions about life insurance trusts, or if you would like to set up a trust of your own, please contact our office at 978-657-7437. We would be happy to help you get started! You can also book an appointment with one of our experienced attorneys at www.BookMyPlanningSession.com.
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