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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.

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A trust can also "protect children from themselves," said 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.

Patrick Hicks, estate planning attorney at Trust & Will, said it’s vital to consider how life insurance processes should be managed after you’re gone. 

“Even basic planning for life insurance proceeds can significantly increase the impact on your family,” Hicks said. “The best planning strategy begins with simply identifying your beneficiaries and considering how you would like the life insurance proceeds to impact them. This is particularly important for parents of younger children.”

Insurers may require a guardian before a child under 18 gets death benefit proceeds. This situation can cause time-consuming barriers. 

The flip side is that a child could turn 18 and get the full death benefit. Handing an 18-year-old hundreds of thousands of dollars is also not a wise decision. 

Instead, naming a trust as the life insurance policy beneficiary provides flexibility, Hicks said. 

Using a trust to hold life insurance proceeds makes it easy to control when and how the proceeds will be distributed. The trust would manage the proceeds in the trust and distribute the proceeds as you choose. Many parents choose to distribute the proceeds in stages over time, helping ensure that the proceeds will be beneficial throughout life,” Hicks added. 

 

Benefits of life insurance trust

life insurance trusts

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.

Also, 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.

Two common types of trusts

The two most common life insurance trusts are Irrevocable Life Insurance Trusts (ILITs) and Revocable Living Trusts, Hicks said. 

  • Revocable Living Trusts -- These trusts are the most common type. They’re much easier and apply to more people than ILITs. With a Revocable Living Trust, you can name a beneficiary of a new or existing life insurance policy and hope that person follows through on your requests. For that reason, it’s critical that you name a beneficiary who you trust and know will follow through. “Revocable Living Trusts are also not limited to just life insurance -- they can be a great way to plan for any other assets and they can even be the beneficiary of retirement plan proceeds,” Hicks said. 

  • Irrevocable Life Insurance Trusts (ILITs) -- ILITS let you plan for when and how to distribute death benefits. The proceeds aren’t usually counted toward the federal estate tax threshold. That could minimize estates taxes if you leave a large estate. “The federal estate tax threshold is currently over $11 million per individual, so most people are not affected. That means the defining feature of an ILIT might provide little or no benefit to most people,” Hicks said. 

“If your estate is large enough that estate taxes are a threat, an ILIT might be worth the additional complexities. Otherwise, a Revocable Living Trust is an easy and effective way to plan for how life insurance proceeds should be managed and used after death,” Hicks said. 

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.

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 is $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.

Best strategies for children’s trusts

Timothy Christ, adjunct professor at St. Edwards University in Austin, TX, said the best strategies for underage children depends on a household’s financial worth:

  • Families with less than $500,000 net worth -- Parents would likely do best with a will, power of attorney or an advanced medical directive. Why? Christ said trusts are costly. That cost likely doesn’t outweigh the benefit. Parents should purchase 10-12 times their annual income in level term life insurance. Whole life insurance isn’t necessary, Christ said.

  • Families with net worth between $500,000 and $2 million -- A will, power of attorney, an advanced medical directive or designate a “living trust” in the will, in case both parents die before the child turns 18. Similar to the previous net worth level, Christ suggested parents buy 10 to 12 times their annual income in level term life insurance. 

  • Families with net worth more than $2 million -- A will, power of attorney and an advanced medical directive is a good idea, but parents should create an estate plan. 

Christ said life insurance is only necessary if you have someone relying on your income. That could be underage children, older children with special needs and elderly parents. Term life insurance is a wise choice in your 20 to 40s as you build retirement investments. Christ does not suggest whole life because of its cost. 

“People need financial education and budget planning, but they don’t need whole life insurance. You can buy 20 times the policy in level term that you can buy for whole life. If I die, would my spouse rather get a $1 million dollar policy or a $75,000 policy? The premiums are exactly the same,” Christ said. 

Ed Leefeldt contributed to this report.