Designating Beneficiaries Of Life Insurance Owned By A Trust
If you own life insurance on your life, when you die the value of your life insurance proceeds will be part of your estate. Even though your life insurance beneficiaries will receive their proceeds income tax free, what they receive may be reduce by your estate tax obligations.
Letting a trust own the life insurance on your life, removes its proceeds from your estate tax obligations, but how best to designate the beneficiary(s) of the trust-owned life insurance?
First of all, for the life insurance proceeds of a trust to remain outside of your estate, you can’t control the trust. So the trust must be irrevocable. It’s ruled only by the its trustee according to the trust document. A typical (revocable) living trust won’t do; it’s treated an extension of you and is part of your estate when you die.
If the purpose of the trust is to own life insurance for the benefit of its trust beneficiaries, then it’s generally called an irrevocable life insurance trust – an ILIT for short. You (grantor of the ILIT) can transfer your life insurance policies to it or have the ILIT buy a brand new life insurance policy on you.
If you transfer your policies to the trust you must do so at least 3 years before you die; or else their death proceeds will remain in your estate. Federal estate tax laws don’t permit ‘deathbed’ gifting. Transferring your policies may be the only way to go if you can’t qualify for a new life insurance policy on you.
If you can qualify, then have the ILIT purchase a policy on your life. Be sure that the ILIT is in existence before the policy comes into existence. Otherwise you’re back to the 3-year wait policy.
*Who should be designated the beneficiary of your ILIT-owned life insurance?
In most cases, it makes better sense to name your beneficiaries individually on life insurance policies versus naming a trust as beneficiary. But, if your beneficiaries have creditor issues, mental health problems, can’t be trusted with large sums of cash or their primary beneficiaries are minors or have drug issues, or there other special scenarios, then naming the trust as beneficiary might be a better route.
If an individual is named a beneficiary life insurance proceeds he can receive the amount free of income tax. But trusts are not considered individuals, so life insurance proceeds paid to trusts are generally taxable. Also, the proceeds payable to a trust may not qualify for the inheritance tax provided by some states for insurance payable to a named beneficiary. In such states, a higher tax may be owed.
Realize that purchasing life insurance involves costs, fees, expenses and potential surrender charges and depends on the health of the applicant. Not all applicants are insurable.
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