All too often, life insurance planning comes to a halt once an adequate amount of insurance has been purchased. Many people never consider what will happen to their insurance proceeds after they are distributed.
Are your spouse, your children, your grandchildren, or other beneficiaries used to handling the large sums frequently paid under life insurance contracts? Will they know how to invest such amounts wisely? Or, through inexperience or lack of proper guidance, will they make costly errors that will adversely affect the financial security you have planned so carefully to provide?
Insurance planning is like any other assignment or project. You must complete several steps in sequence before the task can be considered finished.
The First Step
The first step is deciding how much insurance you need. You can use one of several common “rules of thumb” for determining your optimal life insurance coverage. One of these rules calls for life insurance in an amount equal to five times your annual salary. Another suggests that you have sufficient life insurance to replace 75%-80% of the after-tax income needed by your beneficiary if the beneficiary will have minor children to support, or 65%-70% of needed income if the beneficiary won’t have to care for minor children.
However, most financial planners prefer not to use these pat rules. Because each person’s individual and family needs are different, adequate coverage may not be secured through the use of simple formulas. To determine how much life insurance you need, you have to answer two questions: (1) How much death benefit will my family need to maintain their current income level; and (2) How much liquidity will be needed to cover expenses and death taxes? Answering these questions requires an in-depth analysis of your family’s needs and circumstances. Your insurance advisor can help you with this analysis. And we’d be happy to assist in any way we can.
The Second Step
The next step is choosing the right kind of insurance to meet your needs. All insurance policies agree to pay an amount of money if you die. But all policies aren’t the same.
There are three basic types of life insurance:
Other insurance products are available in addition to these basic types.
- Term Insurance. Term insurance is death protection for a “term” of one or more years. Death benefits are paid only if you die within that term. Some term policies are convertible. Any time before the end of the conversion period, you may trade the term policy for a whole life or endowment insurance policy, even if you aren’t in good health.
- Whole Life Insurance. Whole life insurance gives death protection for as long as you live. The most common type is called “straight life” or “ordinary life.” You pay premiums for life or until you cancel the policy. Policies with cash values may be used as collateral for loans.
- Endowment Insurance. An endowment insurance policy pays you — as the policyholder — a sum if you live to a certain age. If you die before reaching that age, the death benefit is paid to your beneficiary.
The Third Step
The third step is to think about what will happen to your life insurance proceeds once those proceeds have been distributed. If you are at all unsure about how well your beneficiaries will manage the proceeds, you should consider a life insurance trust.
A Typical Life Insurance Trust
Like all trusts, a life insurance trust is a legal arrangement. But don’t let that discourage you! Life insurance trusts are relatively easy to set up.
You, as the grantor of the trust, name the trustee of the trust, usually a financially sophisticated advisor such as Investors Independent Trust Company. Steps must then be taken to insure the trust is the beneficiary of the policy.
When you die, the trustee collects the insurance proceeds, invests them prudently, and distributes trust income and principal to your family or other trust beneficiaries according to the directions you have given in your trust agreement. With a life insurance trust, you decide when, in what amounts, and in what manner the insurance proceeds and/or the income generated by those proceeds will be distributed to your beneficiaries. In short, you, the insured, make the major decisions regarding the disposition of the trust fund.
Life insurance trusts may be revocable. You can amend or even terminate this type of trust arrangement at any time. Or they can be irrevocable, in which case you can’t reserve the right to terminate the trust or change the trust’s terms.
Advantage One: Control and Flexibility
Just how flexible is a life insurance trust? Consider these points:
Advantage Two: Estate Tax Savings
- A life insurance trust gives you more leeway in determining how your proceeds will be distributed. For example, you can give your trustee the discretionary power to invade the trust principal in the event of a family emergency or to finance a child’s or grandchild’s education. Thus, if your family (or other beneficiaries) needs additional funds, your life insurance trust can provide them. Most insurance companies offer only a limited number of distribution options.
- You choose your trustee. By naming a trustee who is experienced in investments and other financial matters, you can be certain that the insurance proceeds will be properly collected, professionally managed and invested according to your beneficiaries’ needs and your stated objectives.
- The trust can protect the interests of minor children without the expense and complexities of court-appointed guardianship. Your trustee can use the trust assets on behalf of your children — in essence, acting as guardian of the insurance proceeds.
- A life insurance trust can unify your estate plan. When you die, your will can provide for the remainder of your estate assets (after taxes, expenses, and claims are paid) to be “poured over” into the life insurance trust so that all your assets can be administered by a single trustee.
- A life insurance trust can protect your beneficiaries from claim of creditors.
A life insurance trust can also save you estate taxes. But you have to meet strict requirements:
If your life insurance trust is properly implemented according to Internal Revenue Code requirements, your life insurance proceeds won’t be included in your estate. The funds will be fully available to your beneficiaries. There are gift tax implications involved with this type of trust. However, with proper planning, gift taxes can usually be avoided.
- You must transfer the insurance policy to the trust more than three years before your death, or the trust itself must purchase the policy (certain other requirements apply).
- You must not have any incidents of ownership in the life insurance policy. Once the trust is set up, you can’t exercise any control over the policy or retain any rights to ownership of the insurance.
- You must make the trust irrevocable.
An additional planning idea is to combine a Life Insurance Trust with "Crummey" provisions. This allows the Grantor to contribute up to $11,000 to the trust with no gift tax consequences. The gift is then used to pay the premium on a substantial life insurance policy. The huge benefit to this approach is that the proceeds of the life insurance are payable to the beneficiary of the trust with no estate tax, income tax or gift tax to pay. It can be a tremendous tool for the creation of wealth for future generations.
How Much Can You Save?
The estate tax savings depends, of course, on the size of your estate. To give you some idea, though, here’s an example.
Let’s say you have a $2 million taxable estate. Of that estate, $500,000 is term life insurance. You don’t have a life insurance trust. After taking the unified credit available to every estate into account, the estate tax on your estate will be approximately $500,000. (Currently, the unified credit exempts up to $1 million in assets from estate and/or gift tax.) If you use a life insurance trust to remove the life insurance from your estate, your taxable estate will be reduced to $1.5 million. After your unified credit is applied, your estate tax will be $250,000. The trust has, in effect, saved your family $250,000 (for a calendar year).
Should you have a life insurance trust? The answer to that question depends on your personal situation — the size and complexity of your estate, your beneficiaries’ financial experience (or inexperience), the ages of your children, and so on.
• Revocable Living Trust
• Marital Trust
• Family Trust
• Generation Skipping Trust
• Dynasty Trust
• Life Insurance Trust
• Charitable Trusts
• Special Needs Trusts