Last updated on May 16, 2017 at 02:40 pm
Many clients ask me about the advantages of life insurance trusts. It seems like something many of you might be interested in if you are seeking ways to set up your estate to leave money to underage children. Trusts ensure that money, which is managed by a trustee, is set aside and made available to them when they reach the age you have designated.
What is it? A life insurance trust is set up for the sole purpose of owning a life insurance policy. When an individual purchases a life insurance policy, the proceeds are subject to estate tax when the owner dies. However, if the life insurance policy is held by a trust rather than by an individual, the proceeds are not subject to estate tax.
What are the advantages of life insurance trusts? This seems like a pretty straightforward distinction. This arrangement could represent savings of thousands of dollars in estate taxes, but it is not without its disadvantages.
What are the challenges? First of all, once the beneficiaries of the trust have been named, they cannot be changed. This can be serious because if situations change over the years, the insured will not be able to adjust the policy appropriately. For example, if the insured names his children as beneficiaries and then has a falling out and becomes estranged from them, they will remain as beneficiaries of the insurance policy as he originally designated. Not only do the beneficiaries remain unchanged, the trust itself is irrevocable. This means that once the trust has been set up as the owner of the life insurance policy, the decision cannot be reversed. As an irrevocable trust, it cannot be altered.
Secondly, the insurance trust does not have the flexibility to allow the insured to borrow against it as one might borrow from an insurance policy.
Thirdly, trust funds cannot be taken by a third party. So if you get into a car accident and it is your fault, and if it is a fatal accident, and the other party sues, they can recover past your auto insurance and into your life insurance. But, they cannot get at the life insurance policy if is in held in a trust. (This would possibly defeat the whole purpose of being insured)
Lastly, if you already have an existing life insurance policy, and you decide to transfer it into a trust, you must live for three years after the transfer to avoid estate taxes. If you die in less than three years after the transfer, the policy will still be taxed as a part of your estate. (The ruling that the trust must exist for three years prior to your death enables the IRS to prevent quick transfers into a life insurance trust just before a death in order to avoid taxes.)
What does this mean for you? The advantages of life insurance trusts are that you can minimize or totally avoid estate taxes so that your heirs will receive the full payout from your life insurance policy instead of facing significant estate taxes. You will give up ownership of the trust and you will give up the ability to change your mind regarding the beneficiaries, but for many, the advantages outweigh the obstacles. You will need to name a trustee to manage the trust for you and to make sure premiums are paid into the trust to keep the policy in force.
Ken Bagner is a member of Sobel & Co. LLC. He is a member of the American Institute of Certified Public Accountants and the New Jersey Society of Certified Public Accountants. Plymouth Rock in New Jersey is proud to partner with NJCPA to bring you valuable tips for about your financial health. Qualified members of the NJSCPA can receive a discount on their car insurance through Plymouth Rock Assurance.