This is because when your life insurance remains within your estate, it’s subject to heavy taxation, which can limit how far your money can go in supporting your loved ones after your death.
“We do a lot of planning with people who currently own life insurance, and now they’re facing estate tax liability issues because their assets have grown from the original time they bought it,” Doll says. “For this reason, we typically suggest you gift that policy to a trust to help your money go further and avoid taxation.”
Trusts and life insurance: Which type of trust arrangement is best for life insurance?
However, not all trusts are created equal when it comes to which type should own your insurance policy. For your life insurance to remain outside of your estate, it needs to be owned by an irrevocable trust.
Terry Ruhe, senior vice president and regional trust manager for U.S. Bank, explains how you can use this setup to better leverage your wealth and leave a lasting impact. “The irrevocable life insurance trust is a way that people can make gifts to a trust and then purchase life insurance using their annual gift exclusion,” he says. “Since everyone has an annual gift exclusion, which in 2024 is $18,000, the amount may be gifted on behalf of each current beneficiary to use for (premium) payments, as needed. So, instead of gifting monies directly to your kids [or other beneficiaries], you could leverage your gift by purchasing a life insurance contract in trust. By not owning the insurance individually, the eventual death benefit would not be taxed in an individual’s estate.”
There are also arrangements like spousal lifetime access trusts (SLATs), which Doll has seen used as a sophisticated technique to utilize the sale of assets and gifts. “The SLAT can absorb the lifetime [gift] exemption and use the assets that you gift to pay the premiums on a life insurance contract to increase the value of a trust,” he explains.
In short: If an irrevocable trust owns your life insurance contract, it offers major benefits for your estate planning. “It just makes a lot of sense to do if you look at the internal rate of return,” says Doll. “I’ve seen people set up an education fund for multiple generations, all of which just started from a life insurance contract.”
What role do beneficiaries play?
It’s not enough to set up a trust to own your life insurance policy, however. Choosing the right beneficiaries is just as important to ensuring that your life insurance policy helps support the people you love without facing heavy taxation. You don’t want a trust to be the beneficiary of your life insurance policy; you want the trust to own the life insurance policy.
You should also set up your beneficiaries appropriately so there is no confusion about gifting or taxation. “There’s an arrangement you want to avoid that’s referred to as the Goodman Triangle,” Doll explains. “Let’s say you are the insured, and the owner of the policy is your spouse. If you list your kids as the beneficiaries, that deems the insurance proceeds a gift, and that means they’re subject to taxation. Ideally, your spouse is the owner, you are the insured and your spouse is the beneficiary.” This can help ensure your assets are passed on to your family without facing heavy fines or taxes.
In many cases, having a corporate trustee is an even better move, since the documentation of these plans has to be rigorous and thorough. “If you had a person serving as trustee and they didn’t take all the proper precautions to document things appropriately, the IRS could challenge it, still questioning whether it qualifies as a gift—and that would be a real detriment,” says Ruhe.
Does life insurance go through probate?
Another reason for a trust to own your life insurance is to avoid the probate process. Probate is typically a lengthy and costly process supervised by the courts that goes through your last will and testament, paying any outstanding debts with funds from your estate and disbursing assets to your beneficiaries. This process can be drawn out over a long period of time—even months or years after your passing.
Having a trust own your life insurance helps avoid the probate process entirely and can make the distribution of assets simpler for everyone involved.
Strategic use of life insurance for financial security
The bottom line for life insurance as it relates to an estate is that transferring ownership to a separate entity outside of your estate—preferably a trust—can help you avoid heavy taxation and the complications of probate. It’s also wise to be strategic about your beneficiaries to help minimize the impact of estate taxes and maximize the impact your assets can have on the loved ones you leave behind.
Working with a financial advisor can help ensure your estate plans are carried out according to your wishes and help your money go further towards supporting your family long after you’re gone.
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