Life Insurance

How to List Beneficiaries for Life Insurance While Having a Trust

With life insurance policies protected from creditors in most states, the tax treatment is the next big issue for consumers. Tax treatment as it relates to ownership and beneficiary designations can be a source of confusion. The topic gets tricky because it involves U.S. ordinary income taxes (for the beneficiary) and federal estate taxes (on the estate tax return of the deceased).

Key Takeaways

  • If your estate is over $2 million, it may be wise to place your ownership of any life insurance in an irrevocable life insurance trust.
  • Proceeds of a death benefit payout will not be included as part of your taxable estate if a trust, not an individual owns the policy.
  • For most people without high net worths, naming beneficiaries individually on life insurance policies makes more sense than opening a trust.
  • Spouses can pass assets estate-tax-free upon one of their deaths.
  • A trust is an entity, not a person, which makes a difference when it comes to life insurance policy payouts.

Trust Ownership of the Policy

If your life insurance beneficiary is your spouse, there’s no issue; assets pass estate-tax-free between spouses no matter the amount (as long as the spouse is a U.S. citizen).

However, depending on what state you live in, if your estate is large (more than $2 million), you may want to consider putting ownership of your life insurance policy in an irrevocable life insurance trust (ILIT) in anticipation of the taxes due at the death of the surviving spouse. While the federal estate tax exemption is currently $11.58 million, a number of states have exemptions that are much lower.

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Why? By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 40%. Revocable trusts will not qualify for the exclusion. If the policy is new, name the trust, as opposed to a will, as the owner immediately. If the policy exists, you can transfer ownership to the trust.

Be aware that to eliminate deathbed transfers, the government mandates that you must survive the transfer by three years or your estate will be taxed anyway. Also, if the value of cashing in the policy before you die is more than $15,000 in 2021 or $16,000 in 2022, the transfer may use up part of your gift and estate tax exemptions.

If you name your spouse as the beneficiary of your life insurance policy, there are generally no tax liabilities pertaining to the lump-sum payout.

Life Insurance Beneficiaries

In most cases, it makes better sense to name your beneficiaries individually on life insurance policies versus naming a trust as a beneficiary. If your beneficiaries have creditor issues, suffer from mental health problems, can’t be trusted with large sums of cash, or have primary beneficiaries who are minors or have drug issues, or if other unique scenarios apply, then naming the trust as beneficiary might be a better route.

For federal tax purposes, if a spouse is named as the beneficiary, then life insurance proceeds received upon the death of the insured are generally income- and estate-tax-free (if paid in a lump sum).

Trusts are not considered individuals; therefore, life insurance proceeds paid to trusts are generally subjected to estate tax. Also, the proceeds payable to a trust may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. In such states, a higher tax may be owed.

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Advisor Insight

Steve Kobrin, LUTCF
The firm of Steven H. Kobrin, LUTCF, Fair Lawn, NJ

Was the trust set up to hold on to your life insurance policies? If so, why wouldn’t you make the trust the owner and beneficiary of the policies? The trustee would then disburse the proceeds according to your wishes.

Let’s now focus on the beneficiaries. Are these people whom you want to receive the life insurance benefit? If you want them to be paid the proceeds directly, then you shouldn’t have the benefit paid to the trust.

You need to think through some basic estate planning principles:

  • Who do you want to get your money?
  • How much do you want them to get?
  • What assets do you want to give them?
  • When do you want them to get it?

The answers will help you determine how much control you want to exercise with a trust and other tools that can execute your wishes when you are gone.

What Are Some Basics of Naming a Beneficiary of a Life Insurance Policy?

What Are Some Cautions With Respect to Naming the Beneficiary?

If any of your beneficiaries have mental health or addiction problems, can’t be trusted to manage or make wise decisions with a large inheritance, or any other reasons, it might be wise to place the money in a trust, with directions for the trustee on how to distribute the funds to your heirs.

The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.

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