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Every life insurance policy must have a beneficiary, which is the person or entity that receives the proceeds of the policy when the insured dies. The beneficiary can be one or more people, such as the spouse and/or children of the insured, or it can be a trust.
A trust is a legal entity that is created to hold property for the benefit of another person or people.
A trustee is named, who administers the assets of the trust for the benefit of the beneficiary or beneficiaries. A trust can stipulate how the assets are to be administered.
Many people use a life insurance beneficiary trust to own their life insurance policies.
This type of trust provides advantages over the alternative scenario, in which you or your spouse own your own policies and you name each other and/or the children as your beneficiaries.
What a Trust Does
When you create a life insurance beneficiary trust, sometimes called an irrevocable life insurance trust or ILIT, the trust usually owns the insurance policy. The trust is also named as the beneficiary of the policy.
When you die, the proceeds from the policy go into the trust.
The trust documentation will detail who benefits from the trust and how the assets of the trust are to be distributed. Let’s look at an example. You establish a life insurance beneficiary trust and purchase a life insurance policy.
You name the trust as the beneficiary of the policy. You name your spouse and your three children as beneficiaries of the trust.
In the trust, you can specify what happens to the proceeds of the life insurance policy. You can stipulate that your spouse receives half of the proceeds as a lump sum, or you can state that they will receive a monthly payment, or a stream of income from the proceeds.
You can specify that your children will receive a lump sum or income stream beginning when they reach a certain age, like 18 or 21, or when they reach a certain life milestone, like graduating from college.
The trust will name the trustee, who is the person responsible for managing the money in the trust, including making the decisions about how to invest it and how to disburse it.
The powers of the trustee are outlined in the trust, but you should make sure that the trustee understands your intentions so that they can administer the trust the way you want.
Minor children, or those under the age of legal majority which is usually 18, cannot receive the proceeds from a life insurance policy. For this reason, a trust is often created when someone wants to take out a life insurance policy and name beneficiaries who are minors.
The money is held in the trust, used for the children’s benefit as the trustee sees fit, and then passed on to the children when they become adults, or as the trust dictates.
You can name a guardian for your minor children, but this provides less protection than a trust. If you die while your children are minors, the proceeds from your life insurance policy will be passed on to the guardian, who will then be able to manage the funds on behalf of your children.
The guardian has considerable leeway in how the money is managed and distributed, so the best way to control the way the money is used is by creating a trust.
If you believe you may have more children in the future, you can provide for them in the trust as well. The beneficiaries of the trust can be your existing children and any future children. If you want to leave the money equally to all of your children, you can specify that in the trust.
There are two ways to describe the way you want the money to be divided. You can leave money to your children “per stirpes,” which means that the money goes equally to each child, and to the descendants of any child who predeceases you.
Suppose you had three children and one of your children died before you, leaving two children of their own. If your trust specifies that your children are beneficiaries per stirpes, each of your two living children gets one-third of the inheritance, and the two grandchildren of your deceased child split the last third, getting one-sixth each.
The other way to pass the proceeds on to your children is “per capita,” which means that the money will be evenly divided among your living children. The family members of any children who predecease you do not inherit. In the previous example, each of the two living children would get half of the proceeds.
The grandchildren (the children of your deceased child) would get nothing.
There are also tax advantages to having a life insurance beneficiary trust own your life insurance policy. The proceeds from a life insurance policy are passed on to the beneficiary free of federal income tax.
However, if you own the policy yourself, the face value of your policy is included in your taxable estate when you die.
For example, if you have $5 million in assets plus a $5 million life insurance policy that you own, your estate, for purposes of calculating estate taxes, is $10 million.
If the life insurance policy is owned by a life insurance beneficiary trust, your estate is valued at $5 million.
As of 2013, estate tax kicks in once your estate passes $5 million, with this number indexed for inflation each year.
So in the example, the owner of the life insurance policy can determine whether you are subject to estate tax or not.
In addition, if your spouse dies before their share of the proceeds is fully disbursed to them, the remaining share can be passed on to the children without incurring tax as well.
Special language can be also added to the trust to make it a generation skipping trust, which provides tax advantages when leaving an inheritance to your children, grandchildren, and future generations.
In order to provide the tax benefits mentioned above, a life insurance beneficiary trust must be irrevocable. This means that, once it is established, it cannot be dissolved. In other words, you can’t change your mind.
In some very limited circumstances, changes may be able to be made to an irrevocable trust.
Generally, however, you should make sure that the trust is set up in such a way that you will never need to change it.
There are many good reasons to create a life insurance beneficiary trust to own your life insurance policy. By doing so, you can protect your family and ensure that your wishes are carried out exactly the way you want.
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