How and Why to Set Up a Life Insurance Trust for Your Children

Opening a trust allows for more flexibility and control over how proceeds are spent in the event of your death.
Barbara Marquand
By Barbara Marquand 

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If you’ve bought life insurance to cover the cost of raising a child in the event of your death, you may also want to set up a trust to hold the money for them.

Trusts aren’t just for the rich. They’re important tools for young families, too.

“Most people set up a trust as part of an overall estate plan, including creating a will and naming guardians,” says attorney Scott Malin of Lathrop & Gage LLP in St. Louis. “If you have minor children, then it probably makes sense to set up a trust.”

A trust holds property and money for beneficiaries such as your children. You spell out how these assets should be managed and used, and appoint a trustee to oversee the process.

Here’s how a trust can come into play when you're buying life insurance: Instead of naming your kids as beneficiaries on your life insurance policy, name the trust and trustee. If you meet an untimely end, the trustee will manage and spend the money according to the rules you set for the trust.

Be careful when naming beneficiaries

Why not just name your kids as beneficiaries on your life insurance policy?

If you die while your children are still minors, then the life insurance company can’t pay benefits until the court appoints a guardian. That takes time and money for attorney fees and court costs.

Instead of setting up a trust, you can name an adult custodian to manage your children’s inheritance under the Uniform Transfers to Minors Act (UTMA). A life insurance agent can help you set up a UTMA account and name the custodian when you buy a policy. If you die while your kids are still young, the custodian will supervise the money until they reach legal adulthood — usually at 18 or 21, depending on your state. Then your kids will receive whatever cash is left.

Advantages of a trust

Passing on a lump sum might work if you have a small policy, says certified financial planner Guy Baker of Wealth Teams Solutions in Irvine, California. But would you want your 18- or 21-year-old to get a huge windfall with no strings attached? Baker has rarely seen people use the UTMA option.

Says Malin, “Even if your children are responsible, they don’t necessarily have the experience and wouldn’t know what to do with the cash.”

That naiveté could leave them financially vulnerable.

A trust provides more flexibility than a UTMA transfer. For instance, you could arrange for a trust to pay for your children’s upkeep and college educations. Then it could distribute portions of the remaining money to your children at specified times, such as their 25th and 30th birthdays, Baker says.

Types of trusts

Trusts can be either revocable or irrevocable. You can change, or even end, a revocable trust during your lifetime. You can’t undo an irrevocable trust.

Unless you are very wealthy, a revocable trust probably suffices, Malin says.

Wealthy people can use irrevocable trusts to protect their heirs from estate taxes — the taxes the federal government and some states charge on property when it’s transferred to heirs. Property in an irrevocable trust is generally not counted as part of an estate for tax purposes.

For 2019, federal estate taxes apply only to estates worth more than $11.4 million per individual or $22.8 million per couple. These thresholds change each year, depending on the rate of inflation. The vast majority of estates are too small to be affected by federal taxes.

If you have a disabled child, you may want to set up a special needs trust. People with disabilities generally cannot have more than $2,000 of assets in their names and still qualify for government assistance programs. A special needs trust can hold assets, such as life insurance money, for your child, without disqualifying them from Medicaid, federal and state health insurance programs, or Supplemental Security Income through the Social Security Administration.

A financial advisor can help you with tax planning and choosing the right amount of life insurance, but you need an attorney to set up a trust.

“The key is for families to sit down with someone and discuss these issues thoroughly before committing them to paper,” Baker says.

Once a plan is in writing, he says, it takes a lot of energy to go back and redo it. So it’s best to get it right the first time.

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