How Life Insurance Can Pay a Trust

What a trust is and why families may name one as a policy beneficiary

Life insurance can do more than provide a lump-sum payment to an individual. A policy can name a properly established trust as its beneficiary. When the insured person dies and the claim is approved, the insurer pays the death benefit to the trustee. The trustee then manages and distributes the money according to the written terms of the trust.

What is a trust

A trust is a legal relationship in which one person or institution holds and manages property for the benefit of someone else. The trust document explains who controls the property, who may benefit from it and how the property may be used or distributed.

Grantor:

The person who creates the trust and establishes its instructions.

Trustee:

The person or institution responsible for managing the trust property and following the trust document.

Beneficiary:

The person or group intended to receive benefits from the trust.

Trusts are created under state law, and their legal and tax treatment depends on the trust language, the assets involved and the circumstances of the people using them.

How a life insurance policy pays a trust

1. An attorney prepares the trust document and the appropriate parties sign it.
2. The policyowner names the trust as the life insurance beneficiary using the insurer's required beneficiary designation.
3. The policyowner keeps the beneficiary designation and the trust information current.
4. After the insured person dies, the trustee submits the insurer's claim requirements.
5. Once the claim is approved, the insurer pays the proceeds to the trustee on behalf of the trust.
6. The trustee holds, uses or distributes the proceeds according to the trust's instructions.

Why name a trust as beneficiary

Providing for minor children

Insurance companies generally do not pay a death benefit directly to a minor. A trust can give a trustee authority to use the money for a child's health, education, housing and other needs until the child reaches the age or milestones stated in the trust.

Controlling when money is distributed

Instead of one unrestricted payment, a trust may direct distributions over time or for specific purposes. This can help when beneficiaries are young, financially inexperienced or likely to need long-term support.

Supporting a beneficiary with special needs

A carefully drafted special-needs trust may help provide supplemental support without giving the beneficiary direct control of the insurance proceeds. Because eligibility rules are complex, this requires advice from an attorney who understands public-benefit planning.

Creating consistent family instructions

A trust can give one trustee written instructions for several beneficiaries, family obligations or long-term goals. This may be useful in blended families or when the policyowner wants money managed rather than distributed immediately.

A trust beneficiary and trust ownership are different

Naming a trust as the policy beneficiary does not necessarily mean the trust owns the policy. The policyowner controls the policy during life, including beneficiary changes, loans and other ownership rights, unless ownership has also been transferred.

An irrevocable life insurance trust, often called an ILIT, may be designed to own life insurance as well as receive the proceeds. That arrangement involves separate ownership, gift, estate-tax and administration questions. It should not be created or funded without qualified legal and tax guidance.

Important tax and estate planning points

• Life insurance death benefits are generally not included in a beneficiary's gross income, although interest paid on retained proceeds may be taxable.
• Naming a trust as beneficiary does not automatically remove the proceeds from the insured person's taxable estate.
• Federal estate-tax treatment may depend on who owns the policy and whether the insured retained rights such as changing the beneficiary, assigning the policy or borrowing against it.
• Transferring an existing policy can create gift-tax, estate-tax and other consequences. Federal rules may also apply when a policy is transferred within three years of death.
• A trust may have tax-return, recordkeeping and administrative responsibilities after it receives and invests the proceeds.

Questions to discuss before using a trust

• Who should serve as trustee, and is that person prepared for the responsibility?
• Who should benefit from the trust, and under what conditions?
• Should the money be available immediately, distributed in stages or reserved for specific needs?
• Does the policy beneficiary designation match the exact legal name and date of the trust?
• Who will review the policy and trust after marriages, divorces, births, deaths or other major changes?
• Should the trust only receive the proceeds, or should it also own the policy?

The practical lesson

A life insurance policy can provide money at a critical time, while a trust can provide instructions for how that money should be managed. Used together, they may help protect minors, support vulnerable beneficiaries and carry out a family's long-term plan. The arrangement only works properly when the policy designation, trust document and overall estate plan are coordinated.

Before naming a trust, ask the insurance company what wording and documentation it requires. Work with a qualified estate-planning attorney and tax professional to create the trust, evaluate ownership and tax issues, and make sure the arrangement complies with applicable state and federal law.

Start with a coverage and beneficiary review

Black Apple Group helps individuals and families understand how their life insurance coverage and beneficiary designations work. A review can help identify questions that should be coordinated with an attorney or tax professional before changes are made.

Educational information only. This article is not legal, tax or individualized financial advice. Trust and estate-planning rules vary by state and by personal circumstances.