Death and taxes are a certainty and, with careful planning, funds to cover estate taxes and provide security to loved ones should be too. Life insurance placed within a trust is a proven estate planning solution. When life insurance is used, implementation matters, so it is important to understand and follow best practices.
BENEFITS OF LIFE INSURANCE
At its core, life insurance offers protection, providing an income tax-free death benefit. What’s more, it can offer a savings component via tax-deferred, income growth on accumulated cash value inside the policy. Its applications are multifold: marital planning, estate planning, and equalization of what is passed to beneficiaries.
Life insurance provides clients predictability. For estate and wealth transfer, a safe asset is available that can counter the volatility of other stock, bond, or real estate assets held - all of which may be susceptible to market cycles and corrections.
BENEFITS OF LIFE INSURANCE IN A TRUST
When placed within a trust, the benefits of life insurance are amplified. Irrevocable life insurance trusts (ILITs) can offer access to cash value during the lifetime of a beneficiary - if the trust agreement allows access to the trust’s assets - which could include a life insurance policy's cash value. It also can protect the proceeds of a life insurance policy from estate taxes (e.g., 40% of a $10 million face amount policy would save $4 million) and generation-skipping transfer taxes. Additionally, placing assets, including life insurance, in a trust protects beneficiaries against creditors including ex-spouses. It also establishes an orderly distribution process for funds.
TRUST BEST PRACTICES
This winning combination of life insurance in a trust works best if certain best practices are adopted.
The Right Partners
Working with the right trust and estate attorney and the right life insurance professional is important because of the complexities of estate planning. For instance, a specialized trust and estate attorney may better understand nuances like jurisdictional differences, trustee powers and limitations, and dynastic provisions and limitations. Similarly, working with the right life insurance specialist can increase the likelihood of identifying the right life insurance products, appropriate policy size, optimal carriers, and techniques to fund the premiums that will help navigate gifting limitations.
Timing
Often, it’s best to start informal medical underwriting while a trust is being drafted. Generally speaking, only after the trust is fully executed and established should an application be signed and filed with a carrier. It’s important to have the policy initially owned by the trust to ensure that the policy and trust dates match. The three-year rule in estate planning is a compelling reason to get the timing right. If the grantor/insured gifts the policy to the trust and then dies within three years after that gift is made, the policy proceeds will be pulled back into the estate. And if death is anticipated or imminent (less than three years), gifting is not permitted. Proper timing of a trust’s creation combined with the policy issue date is necessary to reduce planning risk.
Funding
As a start, and particularly for smaller policies, the annual gift exclusion of $16,000 per beneficiary (2022, indexed for inflation) can be used to fund the policy. So, for instance, a husband and wife could gift $32,000 annually for each child for that policy funding.
For larger policies, one way to ensure that a life insurance premium is paid is to gift or sell income-producing assets such as closely held business or LLC interests in real estate in the trust. They can potentially be discounted when transferred into the trust and then a portion of the cash flow can be used to pay for the insurance while the remainder accumulates in the trust. Loans to trusts are another mechanism to get assets into the trust to pay annual premiums.
In some cases, a separate, dry insurance trust—a shell trust without assets—may be established if ownership issues exist or specific generation-skipping transfer provisions are needed, and a separate life insurance policy is needed. A grantor can usually lend money from an existing ILIT to a new ILIT without a tax penalty.
Trustee Selection
The appointment of a trustee really depends upon a family’s needs and the size of the estate: larger families and trusts are more likely to need professional oversight. For smaller trusts, a family member, trusted family friend, or often, an attorney or accountant can serve as the trustee. But as the trust gets bigger, professional trustees should be used. A $100 million to $200 million trust is probably not going to be run effectively by a brother-in-law without proper experience.
Policy Size
Individual circumstances (e.g., assets, future inheritances, liquidity, and charitable bequests) are the ultimate arbiter of policy size, but some general considerations should inform the decision. It might be useful to calculate current and future liabilities as well as current and future liquidity. However, ultimately, it might be more reasonable to project an estate tax bill after the sunset of the current Tax Cuts and Jobs Act starting in 2026, when the exemption resets back to 2017 levels, adjusted for inflation.
Management
Post sale reviews of life insurance, depending on the size of the policy, can occur from every one to three years. Management or administration of policies can include tracking premiums to make sure they are paid. Once paid, there are several tasks you can complete, depending on the policy type, such as: verify proper crediting to the policy, affirm the premiums have been allocated to the proper sub-accounts, and rerun any guarantees to ensure that they are at the originally agreed duration. For policies with secondary guarantees, carriers are more open to remediation if discrepancies are detected early on. It’s important to be scrupulous about tracking payments, because if a carrier deems an owner to be late on payment(s) there might be a big catch-up premium or higher annual payment, or the late payment might adversely affect the integrity of the contract.
Care needs to be given to product particulars. For instance, careful stewardship is needed for variable universal life (VUL) allocations. For indexed policies, tracking when allocations to different index accounts begin is important; performance can be impacted over time if, for instance, you fund on the first day, but can’t allocate until the 15th day. Policy illustrations need to accurately reflect contract specifics so that they match expected outcomes.
Identify and Rectify Mistakes of Previous Advisors
Optimization opportunities may exist if life insurance previously put in a trust is a cash accumulation product when a focus on a death benefit was needed. Often, clients haven’t been well-educated about the options, and there are better products available. This opportunity is agnostic of whether the policy is VUL, indexed universal life, whole life or some type of guaranteed product.
There may also be instances when split-dollar life insurance is not fully understood and has been calculated incorrectly.
TAKE THE NEXT STEP NOW
Life insurance within a trust can be a powerful tool for tax management: providing liquidity for expected estate taxes and reducing the size of a taxable estate. Best practices can optimize and amplify the benefits for beneficiaries. Because estate planning is a nuanced discipline, professional advice is needed to ensure that best practices are used and the life insurance policy and trust are operating optimally. Consult with our firm for advice on how to best create a successful, wealth transfer solution.
This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. To determine what is appropriate for you, please schedule a time to connect. Information obtained from third-party sources are believed to be reliable but not guaranteed.
The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.