Distribution Options for Your Beneficiaries

One of the main reasons cited for creating an estate plan is to care for loved ones. An estate plan allows you to expressly name beneficiaries to your estate, the methods by which the gifts will be distributed, how the distribution is administered, whether there are any conditions on the gifts, and so forth. Most people want to provide for family members, relatives, or close friends. This post will survey some common options for how you can make the gift.

Outright and free of trust

The most straightforward way to provide for someone is outright and free of trust. Upon your death (or your spouse’s death, or after the second of you to die, etc.), the gift is distributed to the intended beneficiary, and assuming they are above the age of 18, the gift is now owned by them. That’s it. For example, if you leave $40,000 to Person X, then upon your death, Person X receives $40,000 to do whatever they want. It works similarly for percentage or fractional gifts, like 25% of your estate, or 1/3 of your estate. The value is calculated, and when the distribution stage takes place, the beneficiary receives that gift as their own. The limitation to this method of giving is that you relinquish all control over the gift. If the beneficiary was going through some life challenges, like a divorce or a bankruptcy, your gift may end up never reaching the beneficiary at all. Or if they face significant debt, your life’s work may have ended up going straight into the hands of the beneficiary’s creditors.

Sometimes a little nuance is needed. Maybe dropping a large sum of money on someone isn’t the best idea under the circumstances.

In Trust

Leaving a gift in trust for someone can provide a lot of flexibility and oversight. This option creates a trust (a separate trust other than your living trust) naming your beneficiary as the beneficiary of this newly created trust. You also name the Trustee managing the assets held in trust. 

These trusts are created after your death. They are sometimes called “beneficiary trusts”,  “inheritance trusts”, “FBO trusts” (“for the benefit of”), “GST trusts” (generation skipping transfer), “dynasty trusts”, or “asset protection trusts”. For the most part, all of those terms can be interchangeable. They all describe an irrevocable trust set up for the benefit of someone other than yourself. “Irrevocable trust” means that the beneficiary is not able to change the terms of the trust (unlike your living trust, which is amendable during your life). The two main reasons someone may want to create irrevocable inheritance trusts is to 1) retain some control over the gift; and 2) protect the gift from the beneficiary’s creditors (think: the beneficiary’s ex-spouse in a divorce, a plaintiff in a judgment against the beneficiary, or from a bankruptcy). By keeping an inheritance in trust, the assets in trust will not “count” toward the assets of the individual beneficiary, and remain somewhat shielded from those creditors.

If you want to provide for a minor (a child under the age of 18), then a beneficiary trust is the way to go. You can name someone as Trustee of the trust to manage the gift for the benefit of the minor child, and that person does not need to be the child’s parent or guardian. You can specify when, if at all, the minor beneficiary is able to take over as Trustee of their inheritance.

Similarly, you can provide for someone who is financially immature or has addiction issues. A trust allows you to provide for someone even when they are not fully capable of providing for themselves.

Supplemental Needs Trust

Sometimes a beneficiary is receiving government assistance that is means-tested. For example, many MediCal and SSI/SSA benefits have eligibility requirements pertaining to a recipient’s income or net worth. If your beneficiary receives a lump sum inheritance, it could disrupt those benefits. The beneficiary would then need to use their inheritance for their care in place of the government benefits, and they would likely end up destitute, back on the government benefits. By leaving the inheritance in a supplemental needs trust, the trust can provide for the beneficiary without disrupting their means-tested assistance.

With trusts, you can place conditions on your gifts. For example, a common condition for parents is that their children be educated before receiving their inheritance. However, what may be clear in your head, may be ambiguous to someone carrying out your instructions. What does educated mean? Does the child need to earn a degree? Two year degree or four year degree? Does the institution need to be accredited? Does the institution need to be located in the United States? Can it be an online institution? You get the idea. You can place any condition on your gift that you like. However, an estate plan is only as effective as it is executable. There needs to be as little ambiguity in the trust terms as possible.

When you work with an estate planning professional, they will field all of the available options, discuss your goals, and assist you with matching your options and your goals. And after all that, an estate planning professional will make sure the documents are drafted correctly, with as little ambiguity as possible.

What is... an ILIT?

This is part of an on-going series of blog posts titled the "What Is..." series, where we attempt to explain, in simple terms, common estate planning terms and concepts. To read other posts in this series, click here.

An ILIT (eye-lit) is an irrevocable life insurance trust. It’s a trust that cannot be changed (irrevocable) that is created to be both the owner and the beneficiary of a life insurance policy. Why would you do this? It’s a way of having life insurance proceeds excluded from a taxable estate. 

Remember that estate taxes are calculated by adding up the value of everything you own at your death, and if it’s over the estate tax exemption, your estate owes 40% of the excess over the exemption amount. Well, “everything you own at death” includes the proceeds of any life insurance policies you owned during life. Essentially, an ILIT allows you to gift the money “out” of your estate during your life, but still have control over the proceeds after you die.

If you’re thinking “what about gift taxes?” you’re on track: The trustee of the ILIT sends a letter to the ILIT’s beneficiaries (called a “Crummey” letter) every time you transfer money into the ILIT to pay for the insurance premiums. It advises the ILIT’s beneficiaries that they can ask for their share of the money within a specified period of time. 

Typically, no one actually asks for their share because the benefits of leaving it in the trust to pay life insurance premiums would result in more money, later. If there’s no money to pay the premium, then the policy will lapse and there won’t be anything for the beneficiary later. By issuing this letter, the money you transfer to the trustee of the ILIT becomes a “present interest” gift. In other words, that letter transforms your transfer of premium money into the trust into a lifetime gift that can be eligible for the gift tax annual exclusion. The annual exclusion allows you to make gifts up to $15,000 per year per person and not result in any gift taxes owed.

There are certain rules: 

1. You can’t be the trustee of the ILIT

2. Because it’s irrevocable, you fund it and you walk away. The trustee is in control of it. 

3. When the insured person dies, the trustee invests the insurance proceeds and administers the trust for the beneficiaries of the trust. 

The ILIT trustee possesses all incidents of ownership in the policy, so the ILIT can provide the insured’s estate with liquidity, while shielding the insurance proceeds or assets bought with the proceeds from estate tax when the insured dies. 

Flipped the other way: if you own the policy and retain control, you can withdraw cash or change beneficiaries as much as you want during your lifetime. This makes it YOUR asset. This also means that the IRS would include the proceeds of your policy in your estate’s value when you die. 

For example: the current exemption amount for an individual is $11.58 million . If you have $10 million in assets, and a $2 million life insurance policy that you control and maintain, then you have $12 million of taxable assets — over the current exemption amount. If, however, the $2 million insurance policy is in an ILIT, then it’s not part of your taxable assets, and you can (assuming it’s done correctly) stay below the exemption amount, and in this case avoid owing estate taxes.

An ILIT can either be funded with an existing life insurance policy, or the ILIT can purchase the policy on your behalf. If you opt to transfer an existing life insurance policy into an ILIT and you die within 3 years of that transfer, the IRS will still include the proceeds in your estate for tax purposes. If you have the ILIT purchase the life insurance policy, you can avoid this, but you must fund the trust with sufficient money over the years to pay the premiums. 

If you and/or your spouse are the chief breadwinner(s) of the household, and that income is abruptly diminished while your children are young and there are substantial monthly expenses, oftentimes families are challenged to make ends meet. For some clients, especially those with young children and who also have a substantial mortgage to pay, life insurance can be a useful tool to “inject” cash into an estate at an unexpected time of need to help pay for your child’s living expenses so that your children’s home would not need to be sold to defray costs.

Make sense? If not, contact us!