There are several common reasons life insurance trusts are used in an estate plan. Life insurance is an extremely valuable financial planning tool, that when combined with the flexibility and protections of a trust, provides some great benefits.
Provide Liquidity for Estate Administration
A common use for life insurance trusts is to provide an easily accessible source of liquidity for the insured’s estate upon their passing. As is often the case, many assets in an estate are illiquid, such as a house. Also, there is often an immediate need for liquidity after a person’s death. The estate may be required to pay taxes and will incur other administrative and legal costs. Therefore, many financial planners recommend a life insurance trust to provide liquidity for their client’s estate plans. When the insured passes, the life insurance proceeds are paid into the trust that is the policy’s beneficiary. These proceeds can then be used to purchase illiquid assets from the estate, thus providing protection for those assets and cash for the estate’s needs. A real-world example where this strategy might be used is to protect a surviving beneficiary, perhaps the spouse or a child of the insured, from being forced to sell a home on short notice to raise cash.
Minimize Federal Estate Tax Liability
Although life insurance proceeds are usually exempt from income taxes, proceeds are not exempt from estate taxes when the insured personally owns or controls the policy. Compared to personally owning an insurance policy, a key benefit of an ILIT is that the trust is the beneficiary of the policy, and the assets owned by the trust are not considered part of the insured’s taxable estate. For insurance proceeds to pass outside of the insured’s estate, the trust must own and be the beneficiary of the insurance policy.
Maximize Generation-Skipping Transfer Tax (GST) Planning Opportunity
An insurance trust can be used to maximize a grantor’s GST tax exemption by using annual gifts to the trust to fund the insurance premiums. Since insurance proceeds in a properly structured insurance trust are excluded from the grantor’s estate, multiple generations of the family may benefit from the trust’s assets free of GST tax.
Avoid Gift Tax
A life insurance trust can be structured in a way that allows the grantor to maximize their annual gift tax exclusion each year with contributions to the trust. Annual gifting enables the trustee to pay the annual insurance premiums while removing a significant amount of assets from a grantor’s estate over time.
Maintain Government Benefits
If a beneficiary is currently receiving government aid, such a Social Security disability income or Medicaid, a life insurance trust can be used to ensure that life insurance proceeds and ongoing distributions from the trust will not interfere with the beneficiary’s eligibility for government benefits.
Stipulate the Distribution of Funds
With a life insurance trust, the grantor can stipulate in the terms of the trust how the insurance proceeds are to be distributed. The trust can provide the trustee with discretionary powers to make distributions to beneficiaries. This could be useful in incentivizing certain achievements, such as graduating from college, or to protect the assets for the intended beneficiaries in blended family situations.
Protect against Creditors
A properly drafted insurance trust can provide asset protection for the life insurance policies held in trust. An irrevocable trust can provide asset protection from creditors of both the grantor and the beneficiaries. Once distributions are made from the trust to a beneficiary, a creditor of the beneficiary can attach any distribution, but as long as assets are held in trust, they can retain creditor protection. Asset protection laws vary from state to state, and several states, including Alaska, Nevada, and Delaware, offer excellent protections for trusts.