How and Why to Set Up a Life Insurance Trust for Your Children
A life insurance trust can give you flexibility and control over how your kids receive your death benefit after you die.
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A life insurance trust allows you to pass money to your kids smoothly after you die, according to your wishes.
If you have millions in assets, life insurance trusts can help you avoid estate taxes on your life insurance death benefit.
You can set up a trust for almost any type of individual life insurance policy.
Buying a life insurance policy is a great way to ensure your kids are financially taken care of if you meet an untimely death. But what if your kids are still minors when you die? Or what if they’re a bit older and you want to make sure they use the payout from your life insurance wisely?
This is where a life insurance trust comes in.
Rather than have your kids or their guardian receive a pile of cash upon your death, a life insurance trust spells out how the payout from your policy should be used, per your wishes.
For example, let’s say you have a life insurance policy that pays $1 million when you die (this is called a death benefit). You can set up a trust so that if you die while your kids are still young, they’ll receive chunks of your policy’s death benefit over time, like when they go to college, get married or turn 40. Some trusts can even control how your beneficiaries are allowed to spend the money.
But a life insurance trust isn’t for everyone. Consider one if:
You have young kids. If your kids are beneficiaries on your life insurance policy and you die while they’re still minors, the life insurance company won’t be able to pay them benefits until the court appoints a guardian. That takes time and money for attorney fees and court costs.
You have a child with a disability. People with disabilities generally cannot have more than $2,000 of assets in their names and still qualify for Supplemental Security Income government assistance payments. A special needs trust can hold assets, such as life insurance money, for your child without disqualifying them from government benefits.
You have a large death benefit and want to control how it’s used. Even if your kids are old enough to receive a death benefit (typically 18 or 21, depending on where you live), are you confident they’ll use that windfall responsibly? With a life insurance trust, your policy’s death benefit can be used according to guidelines you set in the trust, and it may even help dodge hefty estate taxes.
You don't need a separate trust for the sole purpose of holding your life insurance policy’s death benefit when you die. If you prefer, you can attach life insurance to any trust, including ones that hold other assets, like your house or brokerage account.
The pros and cons of a life insurance trust
Before deciding whether to set up a life insurance trust for your children, consider the pros and cons.
Pros
Control. You can control when your kids receive your life insurance death benefit, and even what they spend it on.
Speed. If your kids are minors when you die, the money from your policy’s payout can benefit them faster. This is because trusts avoid probate, a lengthy legal process where the court oversees the distribution of your assets.
Eligibility for government benefits. If you have children with disabilities, a special needs trust may help preserve their eligibility for certain government programs.
Estate taxes. If you have millions of dollars in assets when you die, you may be able to avoid estate taxes that would otherwise be owed on your life insurance death benefit with an irrevocable life insurance trust.
Cons
Complexity. Setting up a life insurance trust involves paperwork, time and sometimes an estate planning attorney.
Cost. You may pay up to thousands of dollars to set up a life insurance trust, depending on whether you do it yourself or hire an estate planning attorney.
May be hard to change. Depending on how you set up your trust, you may not be able to alter it easily.
How does a life insurance trust work?
With a typical life insurance policy, money goes straight to beneficiaries tax-free as a lump sum payment upon an insured person’s death. Beneficiaries are free to use that money any way they wish, whether that’s paying for everyday expenses or splurging on a new sports car.
But transferring your life insurance policy to a trust gives you a bit more control. Here’s how it works:
Create a trust agreement. This includes naming the trust’s beneficiaries (such as your kids) and instructions for how your life insurance policy’s death benefit should be managed or distributed after you die.
Name one or more trustees. Trustees are responsible for managing your trust while you’re alive and distributing the assets after you die, according to the guidelines you make in the trust. Trustees have a fiduciary duty, which is just a fancy way of saying they must act in the best interest of the trust’s beneficiaries. A trustee is typically a close friend or family member. If you want full control of your trust while you’re alive, you can name yourself as a primary trustee and designate a “successor” trustee to take the reins once you die.
Name your trust as a beneficiary on your life insurance policy. Unless you’re a multimillionaire who needs to worry about estate taxes, you can simply name your trust as the beneficiary of your life insurance policy. That way, the trustee will be able to collect, manage and give out your policy’s death benefit when you die. You can even name your trust as a backup beneficiary if you want your spouse to be the primary beneficiary on your life insurance policy. If you are worried about estate taxes or want to make sure your life insurance will be managed properly if you become incapacitated, you’ll also need to transfer ownership of your policy to your trust. If you don’t already have a life insurance policy, you can buy a policy through your trust.
Continue to pay your life insurance premiums. This should be fairly easy if you still control your life insurance policy. However, if you handed over ownership to your trust, your trustee(s) will have to pay the premiums on your behalf while you’re still alive. You can fund your policy’s premiums yourself by sending money to the trust as a gift, which the trustee can then use to make payments.
Depending on how complicated your finances are, you can recruit the help of an estate planning attorney to help you set up a life insurance trust or do it yourself using an online estate planning service if you have a simple estate.
If you don’t already have a will, now’s a good time to make one. A will is a useful way to transfer any remaining assets to your heirs when you die, rather than relying on state laws to determine who gets what. Wills can also spell out who you want to be your kids’ legal guardians if you and their other parent die before your kids are old enough to fend for themselves.
Types of life insurance trusts
When setting up a life insurance trust, you must choose between a revocable and irrevocable trust. There are lots of variations of trusts with provisions that serve special purposes — such as a special needs trust — but they all fall under one of these two umbrellas.
Revocable life insurance trusts
Best for: Most people.
What is it? A revocable life insurance trust, sometimes referred to as a living trust, gives you the most flexibility. You can make changes to it any time and can even cancel it if you decide you no longer need it — for example, if your kids are older and you feel confident they’ll use your life insurance policy’s death benefit responsibly. With revocable trusts, you usually name yourself as a trustee and name a co-trustee or successor trustee to take over when you die.
The upside: You keep complete control over your trust and life insurance policy while you're alive.
The downside: Setting up a revocable trust can be confusing if you go it alone, and it will cost more than simply naming your kids as the beneficiary of your life insurance policy and hoping for the best.
Irrevocable life insurance trusts (ILITs)
Best for: High net worth individuals.
What is it? An irrevocable life insurance trust, also known as an ILIT, is a trust that cannot be changed or canceled easily once finalized. High net worth individuals typically use ILITs to minimize federal estate taxes and, in some cases, state estate taxes. Irrevocable trusts are intended to be permanent, but you may be able to change one under rare circumstances if you get written consent from all trustees and beneficiaries.
The upside: You can avoid paying estate taxes on your life insurance death benefit and may even shield it from creditors or future lawsuits.
The downside: You can’t change an ILIT easily after it’s established. That means no changing beneficiaries, trustees or terms of the trust once the ink dries. ILITs are also subject to specific funding rules.
Which type of life insurance should I put in a trust?
You can put any type of life insurance in a trust, but most people opt for some sort of permanent life insurance. Permanent life insurance policies have a guaranteed death benefit as long as you keep up with premium payments, up to an advanced age such as 95 or 120. They are typically best if you have a child with a disability or if you want to leave an inheritance.
Here’s a brief rundown of some common types of life insurance you may want to consider for your trust.
Type of life insurance | What is it? | Why choose it? |
|---|---|---|
Life insurance that only lasts for a set number of years, typically 10 to 30. | It’s cheap and can help take care of your kids financially if you die during your prime working years. | |
A permanent life insurance policy that has fixed premiums and a fixed death benefit. | It’s the simplest form of permanent life insurance, and you may be able to pay it off early. | |
A permanent life insurance policy that has flexible premiums and a flexible death benefit. | It’s typically less expensive than whole life insurance, and you may be able to pay less in premiums. |
Most permanent life insurance policies have a “cash value” component that grows over time. People can use their policy’s cash value to take out a loan, pay premiums and more. If you put your permanent life insurance policy in an irrevocable trust, you forfeit day-to-day control over how the cash value is used, but you can provide specific instructions in your trust agreement for your trustee to carry out.