A trust is a financial entity created when an individual puts money or assets aside to be managed, invested, and distributed by a trustee. Trusts may assign an individual or an asset management company (AMC) as trustee, to which the terms of the trust may afford varying levels of discretion. Some trusts specify that the trustee can distribute funds “as needed,” while others specify restricted uses or amounts at specific time intervals (see the “Spendthrift trusts” section of our previous blog post).
Life insurance policies are typically “owned” by the policyholder, i.e. the person who applies for and pays premiums on the policy. Life insurance trusts are created when ownership of a policy is transferred from the policyholder to a trustee. Upon the insured’s death, the death benefit will be paid to the trustee and distributed to the beneficiary or beneficiaries by the trustee.
Why use a life insurance trust?
Although life insurance trusts do not typically offer advantages over personally-owned policies to the average consumer, there are a few situations in which creating a life insurance trust may be prudent.
Although recent tax changes more than doubled the exemption threshold for federal estate taxes, estates worth over $11.18 million are still subject to a 40% tax rate. If the death benefit is transferred to the insured’s estate following his or her death (see our previous blog post), it may be subject to estate taxes. However, if the policy was owned by a trustee as part of a trust, it will escape taxation on the insured’s estate since it is not technically “owned” by the insured.
Control over distribution of death benefit
In a typical life insurance policy, the death benefit is transferred from the insurance company directly to the beneficiary or beneficiaries upon the insured’s death. However, life insurance trusts may afford full discretion over distribution of the death benefit to a family member or close friend as trustee, allowing them to control who gets what and when. This can be useful when children or financially irresponsible adults, who could not be trusted with the full death benefit, are named as beneficiaries to the trust. Additionally, since the trustee (rather than the beneficiary) controls the death benefit, it is protected from the beneficiary’s creditors.