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Life insurance trusts for child beneficiaries

In most instances, life insurance companies won't pay the death benefit of a life insurance policy to a minor until he or she turns 18 -- unless a trustee or guardian has been named.

And in some states the children, or other inheritors, may have to deal with estate taxes after a death, while the assets could be tied up in probate court, rendering them unable to pay. Trusts ensure that life insurance money is distributed according to your wishes, without delay.

Trusts are inherently complicated instruments. That's why they're usually preferred by those who can afford a lawyer, and have a lot of assets to protect -- from taxation, creditors and, sometimes, greedy relatives.

But understanding the basics is imperative for anyone who wants to ensure that their money and property go to their children. There are many pitfalls that come with a lack of knowledge.

A trust can also "protect children from themselves," says John McManus, founder of McManus & Associates, an estate-planning law firm based in New York City. "If, at 18, a child gets it all, that could be a massively destructive injection of money."

Instead, the money can be earmarked for health, education or -- with the help of a trustee -- a lifetime trust.

Life insurance trusts not that simple

life insurance trustsFor those of average wealth, a revocable trust, which can be changed and/or revoked if necessary, could be enough.

In some cases, you can simply write the name of the trustee on the beneficiary line of your life insurance policy. However, always check with your life insurance company to make sure. You can also describe the trust in your will.

But, like most legal documents, it's usually not that simple. A trustee has a big responsibility in managing the trust's assets, including the cash from the life insurance policy that can be used to pay immediate expenses after death.

Many trustees have been sued, not only for mismanagement, but also for lack of management. One example is failing to invest the proceeds in the stock market. You may find that the trustee of your choice doesn’t want that responsibility.

If the court has to appoint a guardian, that person will likely take a more conservative approach of putting the money in a bank account because he or she doesn't know your wishes. Therefore, a lawyer can be an immense help in creating specific instructions regarding the use of life insurance money.

Inheritance tax exemption

For the wealthy, an irrevocable trust may be the answer. This type of trust takes a bunch of assets, often including a life insurance policy, and "tosses them over the compound wall," says attorney McManus. In effect, you create a separate corporation to manage them.

An irrevocable trust is clearly a device to protect against taxation; many states and the federal government impose inheritance taxes when the estate exceeds a certain amount. The federal estate tax exemption for 2018 is $11.18 million and it's $11.4 million for 2019. You can find the most recent limits at irs.gov.

An irrevocable trust needs a lawyer's support, because assets placed in this trust can't be taken out, no matter how much your situation changes. You can, however, provide for changes in status when you create the original trust document, such as additional children, divorce, or a special needs child.

In some states, the assets inside the trust, such as a life insurance policy, can be "decanted" like a bottle of wine. They can't be taken out of the trust, but they can be "poured" into a new trust that better meets the revised needs of the person who's making it, suggests Barron's magazine. For example, you could "buy" a life insurance policy from an old trust to put in a new one.

Special needs trusts

For children who may never be healthy or able to fend for themselves, you might want to set up a special needs trust. Again, you need to be careful and engage a lawyer.

Also, there's the question of Social Security and taxes. You don't want a disabled child to "look rich" if he or she could be eligible to collect Social Security disability benefits at the age of 18.

A disabled child can maintain eligibility for assistance because they don’t have control over the money in the trust. The trustee can use the funds to pay for a variety of things for the disabled child, such as education or vacations.

The trustee of a special needs trust should make sure that money from the trust isn't used for food, clothing, shelter, medication or anything covered by Social Security.

Life insurance helps protect your children, but make sure when you're making them beneficiaries that you're taking the right precautions so they benefit fully from your generosity. 

Life insurance trusts and your will

One of the major advantages of a life insurance trust is that the proceeds avoid probate. That means you can designate beneficiaries to your policy and the money will go to loved ones without having to specify this in your will.

The terms of your life insurance trust supersede those of your will. In addition, you cannot use your will to change who will be the beneficiary of your life insurance trust.

Of course, the trust only controls assets that are placed within it. So, make sure to keep that in mind when planning your estate.

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