most states protect life insurance policies from creditors, most buyer questions come from the confusion created with ownership and beneficiary designations because of tax treatment. This is a rather complicated issue when it comes to life insurance proceeds, because there are two tax issues that raise their head: U.S. ordinary income taxes (for the beneficiary) and federal estate taxes (on the estate tax return of the deceased).

Ownership of the Policy
If your life insurance beneficiary is your spouse, generally there's no issue; assets pass estate-tax free between husbands and wives no matter what the amount (as long as the spouse is a U.S. citizen). However, if your estate is large (more than $2 million), you may want to consider putting ownership of your life insurance policy in an irrevocable life insurance trust in anticipation of the taxes due at the death of the surviving spouse.

Why? By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 45%. Revocable trusts will not qualify for the exclusion. If the policy is a new policy, name the trust as owner immediately. If the policy is existing, you can transfer ownership to the trust. Beware: to eliminate deathbed transfers, the government mandates that you must survive the transfer by three years or your estate will be taxed anyway. Also, if the cash value of the policy that you would get if you cashed in now instead of when you die is more than $14,000 (as of 2013), the transfer may use up part of your gift and estate tax exemptions.

Life Insurance Beneficiaries
In most cases, it makes better sense to name your beneficiaries individually on life insurance policies versus naming a trust as beneficiary. If your beneficiaries have creditor issues, mental health problems, can't be trusted with large sums of cash or their primary beneficiaries are minors or have drug issues, or there other special scenarios, then naming the trust as beneficiary might be a better route.

For federal tax purposes, if a spouse is named as beneficiary then life insurance proceeds received upon the death of the insured are generally income and estate tax free (if paid in lump sum). Trusts are not considered individuals; therefore, life insurance proceeds paid to trusts are generally subjected to estate tax. Also, the proceeds payable to a trust may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. In such states, a higher tax may be owed.

For more insight, read Establishing A Revocable Living Trust and Pick The Perfect Trust.

  1. What are the keys to setting up a trust fund?

    Setting up a trust to secure your assets for a beneficiary allows you to set the terms under which the beneficiaries are ... Read Answer >>
  2. What are the restrictions for naming a given individual as my contingent beneficiary?

    Understand what restrictions may exist, depending on your state and the policy you choose, on naming your life insurance ... Read Answer >>
Related Articles
  1. Insurance

    How To Avoid Taxation On Life Insurance Proceeds

    Decrease the value of your taxable estate and prevent the tax man from getting you one last time.
  2. Managing Wealth

    Mistakes to Avoid When You Own Life Insurance

    How to avoid some common mistakes that can cause tax and inheritance problems when you own life insurance.
  3. Financial Advisor

    Passing an IRA to a Trust: The Good and Bad

    Creating a trust is a common estate planning tactic, but naming a beneficiary to an IRA to a trust may have unintended consequences.
  4. Managing Wealth

    Use Life Insurance to Help Those With a Disability

    Why and how to use permanent life insurance to help provide for a family member with a disability or special needs
  5. Financial Advisor

    Why You Need to Find the Right IRA Beneficiary

    It definitely matters who you pick as your IRA beneficiary—and how you go about it. And in some cases, your best option may be to go with a trust.
  6. Retirement

    Who is a Beneficiary?

    A beneficiary is a person or entity that receives funds, assets, property or other benefits from a trust, will, or life insurance policy.
  7. Managing Wealth

    Pick The Perfect Trust

    Trusts are an estate plan's anchor, but the terminology can be confusing. We cut through the clutter.
  8. Insurance

    Cut Your Tax Bill With Permanent Life Insurance

    Learn how to lower your income tax and avoid estate tax - all while building wealth.
  9. Financial Advisor

    How to Handle Client Beneficiary Designations

    Beneficiary designations are a critical financial planning step that can be easily overlooked. Here's how to ensure they are properly done.
  1. Insurance Trust

    An irrevocable trust set up with a life insurance policy as the ...
  2. Named Beneficiary

    This term refers to any beneficiary named in a will, a trust, ...
  3. Beneficiary

    Anybody who gains an advantage and/or profits from something. ...
  4. Charitable Lead Trust

    A trust designed to reduce beneficiaries' taxable income by first ...
  5. Primary Beneficiary

    A beneficiary in a will, trust or insurance policy that is first ...
  6. Credit Shelter Trust - CST

    A type of trust that allows a married investor to avoid estate ...
Hot Definitions
  1. Assets Under Management - AUM

    The market value of assets that an investment company manages on behalf of investors. Assets under management (AUM) is looked ...
  2. Subprime Auto Loan

    A type of auto loan approved for people with substandard credit scores or limited credit histories. There is no official ...
  3. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  4. Federal Debt

    The total amount of money that the United States federal government owes to creditors. The government's creditors include ...
  5. Passive Management

    A style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. ...
  6. Series 7

    A general securities registered representative license administered by the Financial Industry Regulatory Authority (FINRA) ...
Trading Center