This week, I received the following question from a reader.
Q: Hi I read your blog about funding a revocable trust. My husband and I are talking about getting them, but all we have of significant value (besides house, and a money market ($500,000), is life insurance on his life ($2M). Your article says you should keep the beneficiary of a life insurance policy first to a wife then to a trust. Why?
A: Whether to make your revocable living trust the beneficiary of your life insurance policy depends on your personal situation and what your goals are. There is no one-size-fits-all answer to this question, so it is important to have your attorney educate you and assist you in making an informed decision.
Estate Tax Considerations
The first issue to consider is whether your estate is likely to be subject to estate tax. As we discussed in our previous article, How to Avoid Estate Tax, the Illinois estate tax exemption is $4 million. If your estate is worth over $4 million when you pass away, everything over $4 million will be taxable.
Unlike the federal estate tax exemption, the Illinois Estate Tax exemption is not portable, meaning that spouses cannot automatically take advantage of one another's estate tax exemptions. However, by creating a separate revocable living trust for each spouse, we can essentially make the estate tax exemption portable. This would give you an $8 million exemption as a couple, rather than leaving you each with a $4 million exemption. This is called an AB Trust strategy, and it is usually the first line of defense against estate tax.
The bottom line is that if you are using revocable living trusts as an estate tax planning vehicle, the trust should be listed as the primary beneficiary of your life insurance policy as opposed to your spouse. Unless the trust is the beneficiary of the policy, you will not be able to take full advantage of the portability benefits of the AB Trust strategy.
You should be aware that death benefit of your husband's life insurance policy would count as part of the estate for estate tax purposes. When we add the $2 million death benefit, your $500,000.00 money market account, and the value of your house, you are likely getting close enough to $4 million in assets that you may want to consider an AB Trust strategy to raise your estate tax exemption as a couple from $4 million to $8 million. Again, if you choose to pursue this strategy, then one or both of the trusts should be the beneficiary of the life insurance policy.
If you have comfortably less than $4 million in assets when you include the death benefit of your insurance policy, then estate tax will not be a consideration for you. Whether to list your trust as a beneficiary of your life insurance policy is a much more personal decision.
Unlike some other types of assets, your life insurance policy does not have to be transferred to your trust to avoid probate. However, if you are not going to transfer the policy to your trust, we always recommend making sure that you have successor beneficiaries listed after your spouse to ensure that there is a living beneficiary able to inherit the death benefit of the policy when you pass so the death benefit will not be dumped into a probate estate.
So, if the life insurance policy won't affect estate tax or probate if it is left out of the trust, why should you make the trust the beneficiary of a life insurance policy?
If you have minor children when you pass away, you may not want your life insurance proceeds simply paid out to their guardian. Check out our article about what happens when minors inherit property in Illinois. In the absence of a trust there are fewer controls on the guardian misusing the child's inheritance. The inheritance may also be subject to the guardian's creditors.
If your children are young adults when you pass away, you may not want your children to receive the entire death benefit of the insurance policy all at once. Our clients will typically choose to have to have their revocable living trusts provide that their children can access 1/3 of the assets in their trust at age 21, 2/3 at age 25, and the rest at age 30. During this period the trustee will have discretion to pay more than these amounts if he or she believes it is in the child's best interests. This prevents the children from spending the money irresponsibly. If the trust is the beneficiary, rather than the child directly, restrictions in your trust such as these will be able to control the use of your life insurance death benefit.
For this reason, a married person will typically name their spouse as the direct beneficiary of the life insurance policy and name the trust as the successor beneficiary. We want the payout to the spouse to be as quick and painless as possible. However, when the pay out is going to other heirs, we are often willing to sacrifice speed to ensure that your wishes are executed properly.
To sum up:
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