You have three basic choices for estate planning (your property transfer on death): the will, which is the standard method; the living trust, which is rapidly growing in popularity; and beneficiary designations for assets such as life insurance and IRAs. If you die without either a will or a living trust, state intestate succession law controls the disposition of your property that doesn’t otherwise pass via “operation of law,” such as by beneficiary designation. And settling your estate likely will be more troublesome – and more costly.
The primary difference between a will and a living trust is that assets placed in your living trust, except in rare circumstances, avoid probate at your death. Neither the will nor the living trust document, in and of themselves, reduce estate taxes – though both can be drafted to do this. Whether a will or a living trust is better for you depends on many personal factors. Let’s take a closer look at each vehicle.
If you choose only a will, your estate will most likely have to go through probate. Probate is a court-supervised process to protect the rights of creditors and beneficiaries and to ensure the orderly and timely transfer of assets. The probate process has six steps:
1. Notification of interested parties.
Most states require disclosure of the estate’s approximate value as well as the names and addresses of interested parties. These include all beneficiaries named in the will, natural heirs, and creditors.
2. Appointment of an executor.
If you haven’t named an executor, the court will appoint one to oversee the estate’s liquidation and distribution.
3. Inventory of assets.
Essentially, all assets you owned or controlled at the time of your death need to be accounted for.
4. Payment of claims.
The type and length of notice required to establish a deadline for creditors to file their claims vary by state. If a creditor doesn’t file its claim on time, the claim generally is barred.
5. Filing of tax returns.
This includes the individual’s final income taxes and the estate’s income taxes.
6. Distribution of residuary estate.
After the estate has paid debts and taxes, the executor can distribute the remaining assets to the beneficiaries and close the estate.
Probate can be advantageous because it provides standardized procedures and court supervision. Also, the creditor claims limitation period is often shorter than for a living trust.
Because probate is time-consuming, potentially expensive, and public, avoiding probate is a common estate planning goal. A living trust (also referred to as a revocable trust, declaration of trust, or inter vivos (during one’s lifetime trust) acts as a will substitute, providing instructions for the management of your assets, either during your life if you’ve funded the trust, or on your death. You’ll still also need to have a short will, often referred to as a “pour over” will.
How does a living trust work?
You transfer assets into a trust for your own benefit during your lifetime. You can serve as a trustee, select some other individual to serve or select a professional trustee. In nearly every state, you’ll completely avoid probate if all of your assets are in the living trust when you die or your assets are held in a manner that allows them to pass automatically by operation of law (for example, a joint bank account). The pour-over will can specify how assets you didn’t transfer to your living trust during your life will be transferred at death.
Essentially, you retain the same control you had before you established the trust. Whether or not you serve as a trustee, you retain the right to revoke the trust and appoint and remove trustees. If you name a professional trustee to manage trust assets, you can require the trustee to consult with you before buying or selling assets. The trust doesn’t need to file an income tax return until after you die. Instead, you pay the tax on any income the trust earns as if you had never created the trust.
A living trust offers additional benefits:
First, your assets aren’t exposed to public records. Besides keeping your affairs private, this makes it more difficult for anyone to challenge the disposition of your estate.
Second, a living trust can serve as a vehicle for managing your financial assets if you become mentally incapacitated or disabled. A properly drawn living trust avoids potentially embarrassing guardianship proceedings and related costs, and it offers greater protection and control than a durable power of attorney because the trustee can manage trust assets for your benefit.
Who should draw up your will or living trust?
A lawyer! Don’t try to do it yourself. Estate and trust laws are much too complicated. You should seek competent legal advice before finalizing your estate plan. While you may want to use your financial advisor to formulate your estate plan, wills, and trusts are legal documents. Only an attorney who specializes in estate matters should draft the property transfer on death.
Reduce Estate Tax Liability with Life Insurance Trusts
Are you wondering if life insurance trusts are a good idea? Depending on your financial situation and the manner in which your life insurance policy is structured, setting up a trust may be in your best interest, as well as that of your heirs and beneficiaries. Many people mistakenly believe that all life insurance proceeds are exempt from taxation. There are many circumstances under which life insurance is taxable. For example, if an individual’s estate is large enough to be subject to estate tax, the proceeds from a life insurance policy that he or she owns will be taxed at the estate tax rate. However, if ownership of the policy is properly set up from the commencement of a policy in a life insurance trust by an attorney, estate taxes are not applied to those proceeds. See your tax advisor/attorney for further information.
Many factors impact whether or not life insurance trusts are beneficial for particular individuals and their families. If you’re interested in learning about the implications of life insurance trusts for your specific situation, it’s advised that you consult your estate planning attorney before making any decisions and consult with your LifeInsure.com advisor to help guide you.
Three Drawbacks of Life Insurance Trusts
While there are a number of benefits associated with life insurance trusts, there are also several drawbacks. Most people who establish life insurance trusts do so to prevent their heirs from having to pay estate taxes. However, before deciding to set up a trust, it’s important to consider the limitations and implications of doing so. Be sure to discuss your particular situation with an estate planning attorney before making any firm decisions.
Three drawbacks associated with life insurance trusts include:
- Beneficiary Changes are Not Allowed: Once you establish a life insurance trust, you will not be able to make changes to the beneficiary (or beneficiaries) named in the policy or of the trust.
- Policy Cannot Be Used as Collateral: When you establish a life insurance trust, you give up the ability to borrow money against the policy. This is because ownership of the policy is passed to the trust, and you can’t use something that you do not own for collateral.
- Irrevocable Decisions: Life insurance trusts must be irrevocable, which means that you can’t change your mind and decide to take back ownership of the policy. Setting up a life insurance trust is a permanent decision.
There are numerous ways to use life insurance to help pay for estate planning, but the use of an Irrevocable Life Insurance Trust (ILIT) is a place to start.
This article reviews what that Irrevocable Life Insurance Trust is, what it does, and when one should use one. This obviously isn’t the only strategy for use in life insurance for estate planning but is a basic one.
This article was written for LifeInsure.com by an attorney, and when you inquire with us about utilizing life insurance for estate planning and for payment of estate taxes, we will be working with your attorney or can recommend one to you. LifeInsure.com does not give legal advice, but we certainly are familiar with working attorneys for estate planning.
In An ILIT We Trust (Irrevocable Life Insurance Trust)
Life insurance can help you provide for your loved ones’ financial security after your death. However, careful planning is necessary in order to avoid decisions that could threaten the estate-tax-free status of your life insurance proceeds and significantly reduce the amount that’s left for your family – or that could prevent them from receiving the proceeds according to your wishes. Let’s examine two major snafus you can avoid when you employ an irrevocable life insurance trust (ILIT).
1. You own the policy
It’s not uncommon to purchase life insurance to cover estate taxes. But the policy proceeds intended to pay the estate tax bill can end up increasing the bill if you’re not careful. Why? Because even though the proceeds are income-tax-free for the beneficiaries, the money may be included in your estate and, thus, be subject to estate tax.
One way to prevent this outcome is by creating and setting up an ILIT to own the policy. After your attorney sets up the trust and you name the trustee (such as a friend, family member, lawyer, accountant, or bank) and beneficiaries, you can begin making cash deposits into the trust, in essence paying the policy’s premiums. Your cash contributions to the trust to cover premium payments are considered taxable gifts, so a gift tax return may be required. With savvy planning, however, you can minimize or even eliminate gift taxes by using annual gift tax exclusion amounts.
Keep in mind that, for the ILIT to be successful, you can’t retain any incidents of ownership in the policy. This includes the right to borrow against the policy’s cash value or retain the right to change beneficiaries.
Also, try to avoid transferring an existing policy to an ILIT. If you die less than three years after the transfer, the three-year rule will kick in and draw the proceeds back into your estate. By having the Irrevocable Life Insurance Trust buy a new policy on your life, you can avoid this outcome. Bear in mind that if your primary goal is to be able to withdraw funds from the policy during your retirement years, an ILIT probably isn’t the right vehicle for you.
2. A policy beneficiary is a minor or is legally incompetent
You naturally want to ensure that your children will not be harmed financially and will be able to retain business interests and other assets after your death (or the death of you and your spouse). But one of the biggest and most common snafus you can make is designating a minor or legally incompetent person as the beneficiary of your life insurance policy. Doing so defeats the purpose of providing for your loved ones after you’re gone because insurance companies generally won’t pay large sums of money directly to a minor or an incompetent person.
The result? Your executor will have to go through the lengthy and expensive process of arranging a court-appointed guardian before the death benefits are released to your family members. And if the appointed guardian doesn’t have your loved one’s best interest at heart, your plans could go up in smoke. What’s more, in the case of a minor, the beneficiary will gain unrestricted access to the funds as soon as he or she reaches the age of majority, regardless of his or her ability to manage the assets.
Designating an ILIT as the beneficiary of the insurance policy can help prevent this outcome. An Irrevocable Life Insurance Trust provides you with the flexibility to establish detailed criteria for how and when the proceeds will be distributed to or on behalf of your loved ones.
You can instruct the trustee to distribute the funds to beneficiaries at any age you wish, even into adulthood. For example, you can allocate distributions for college tuition or health care or make them contingent on certain achievements, such as graduating from college, becoming active in the family business, or being gainfully employed elsewhere. You can use distributions to reward exemplary behavior, such as becoming involved in a charity, or celebrate certain milestones, such as a birthday or wedding.
For a beneficiary who is severely disabled or otherwise legally incompetent, consider establishing a Special Needs Trust which provides for his or her comfort and cost of living without jeopardizing eligibility for government assistance.
Shielding your estate plan
A life insurance policy can help protect your family’s financial future. An ILIT can help ensure the policy works as you intend by shielding your estate plan from snafus that make policy proceeds vulnerable to hefty estate taxes or prevent the proceeds from being distributed according to your wishes. The Private Client Group at LifeInsure.com can help you determine whether an ILIT is right for your situation and, in coordination with your attorneys, can recommend a beneficial plan to establish the liquidity necessary to pass on assets with minimal estate tax obligations.
(Technical assistance for the information contained in this article was provided by The Law Offices of Afshin A. Asher, with offices in Los Angeles, California.)