Life Insurance-Funded Trusts: A Terrific Resource for Middle Income Planning

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Most people know they should have enough life insurance to take care of loved ones in the event of an unexpected death. Conventional wisdom says your life insurance should cover about 10 times your annual income. Life insurance is limited, however. Depending on your situation, you may want to consider setting up a trust that is funded by life insurance.

Imagine this scenario. You are a husband and father with small children. You want to make sure that if you die unexpectedly, your children will get the benefit of your life insurance. You want to make sure your mortgage is paid off so your wife and children do not have to worry about having a home. You may be concerned about college expenses, but you may also worry what would happen if your wife remarried.

What Happens with Life Insurance?

Under the above example, after you pass away, assume you have $1 million in life insurance that is paid directly to your widow. She can choose whether to use the money responsibly or not. She may not pay off the mortgage. She could remarry. If the money gets co-mingled with her new husband’s income and assets, and they later divorce, much of the money you intended for your children could become subject to a divorce court’s discretion. Likewise, if your widow passes away without making proper arrangements, that money could be shared between your children and the new husband. Worse yet, consider what happens if your wife chooses to not allow your parents and other family members to see your children.

Difference Between Life Insurance and a Trust

Life insurance, unlike a trust, has a limited use. Here are just a few ways these two options differ:

Benefits of Life Insurance

  • Pays cash to loved ones when you die
  • You do not need a high net-worth to have a lot of coverage
  • Does not pass through probate
  • Is not generally subject to estate taxes
  • Is not generally considered taxable income

Limitations of Life Insurance

  • You cannot control how loved ones use the life insurance after your death
  • Does nothing for real estate, tangible property, or other non-cash assets
  • Insurance contract controls everything

Benefits of a Trust

  • A trust can control the use and distribution of your assets for long after death
  • A trust can contain cash, as well as real estate, and tangible property
  • Does not pass through probate

Limitations of a Trust

  • Must have assets to put in the trust
  • Can have tax implications, depending on the type of trust

What Happens When I Die, if I Have a Trust Funded by Life Insurance?

Let’s look at our example again. If your trust is funded by life insurance, the money will not be taxable income. It would be paid to the trust, not your widow. You could name someone you trust to act as the trustee to manage the funds. This means you could set up an annual salary to your widow, pay the mortgage, establish college accounts for the children, and put provisions in place that discontinue or reduce cash payments if your widower-marries or begins long-term cohabitation. You can even set up provisions that would require your widow to permit your relatives to visit and have access to your children as a condition of continued payments.

In short, having a well-drafted trust in place can protect the ones you love even if you do not have a large estate to begin with. Call or click today to speak with an experienced Alabama estate planning attorney who can discuss your options.

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