What is a life insurance trust?

A life insurance trust is a legal agreement that allows a third party to manage the death benefit from a life insurance policy. A trust ensures that your policy's death benefit is distributed to your beneficiaries according to your wishes. It also exempts the funds from probate and may reduce any estate tax owed. Life insurance trusts are commonly used by individuals with a high net worth, as well as parents who want to structure the benefit payments made to their children.

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How does a life insurance trust work?

With a life insurance trust, the life insurance policy is typically owned by the trust itself, while you (the grantor) are the named insured. When you pass away, the trust will receive the policy's death benefit and the person managing your trust (known as the trustee) will distribute the funds to your beneficiaries according to the rules set down in the trust agreement.

You can technically create a life insurance trust from either a term or whole life policy, but whole life insurance is more commonly used since it has a clearly defined and guaranteed death benefit. With a term policy, it's possible that the coverage will expire, leaving the trust unfunded. Likewise, a universal life policy may vary in value over time, making it more difficult to anticipate how much funding the trust will have.

Note that there are two types of life insurance trusts:

Irrevocable life insurance trusts (ILIT)

Irrevocable life insurance trusts, or ILITs, can't be changed or canceled once created. That means whatever assets are placed with the trust will remain with the trust, including the cash value of a whole life policy. Despite these restrictions, irrevocable trusts are a common choice among high-net-worth individuals whose estates exceed the federal estate tax threshold. Since the policy is owned by the trust and not the insured, the proceeds from it aren't subject to the federal estate tax. Learn more about how taxes on life insurance can impact estate planning.

Revocable life insurance trusts

As the name suggests, revocable life insurance trusts can be canceled or modified. These types of trusts are useful for parents who wish to set up guardrails for their children so they can't spend all their inheritance at once. For example, instead of giving your 16-year-old child a lump sum payment, a trust can disburse the funds from your policy in installments over time.

Pro tip:

Setting up a life insurance trust is much more complicated than writing a will. You should consider hiring an attorney who specializes in trusts instead of creating one on your own. Your attorney can set up the trust for you, as well as answer any questions you have along the way.

Is a life insurance trust right for me?

For most people, a life insurance trust may not be necessary. Establishing an irrevocable life insurance trust costs a lot of time and money, and the tax advantages they offer typically only make sense if you have a high net worth.

However, if you have young children, or a child with special needs, then a revocable trust may be a smart option. You can use the trust to control when and how funds are disbursed, providing long-term support for minor or special needs children or keeping a young adult from spending it all at once. As your family situation changes, you can modify the arrangement or cancel it altogether if a trust is no longer needed.

Important note: A life insurance trust may also ensure that a child with special needs is still eligible for government assistance. Since the trust owns the funds from the life insurance policy, they may not count toward income limits imposed by assistance programs.

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