This year, we have worked with a number of clients who are setting up revocable trusts and own life insurance policies on their children. This post explains our clients’ options in this situation.
Understanding the problem
To understand our clients’ options, we first need to understand how these policies are structured. All insurance policies have an owner, an insured, and a beneficiary. The owner is the person who owns the policy. The insured is the person whose life is being insured; the policy will pay a death benefit if the insured dies. The beneficiary is the person who will receive the death benefit if the insured dies.
In most non-business scenarios, the owner is also the insured, and the beneficiary is someone else. So, for example, if I take out a policy on myself and name my wife as beneficiary, I am both the owner and insured, and of course my wife is beneficiary.
The goal of funding trusts, of course, is to make sure that all assets avoid probate by flowing to the trust when they would otherwise flow into a probate estate. So, in the example above, I would name my wife as primary beneficiary and the trust as contingent. If I die and she survives me, the death benefit is paid to her. If I die and she has predeceased me, the death benefit is paid to my trust and avoids probate.
If I take out a policy on my child, however, it works differently. If I die, I am not the insured, so the policy will not pay a death benefit. Instead, if I am the only owner, the cash value will belong to my probate estate. If I have a revocable trust, we want to avoid this.
Available Options
The first option our clients have is the simplest: just give the policy to the child now. Typically, the reason the parent purchased the policy in the first place was so that the child could have it eventually. Giving the child the policy lets them decide to keep it, cash it out, or make changes to best fit their life situation.
The second option is to name the insured child as successor owner. This means that at the death of the owner, the policy will transfer to the child who is the insured. At that point, it becomes like any other policy the child has, and the child can keep it or cash it out. Note that the successor owner is not the same as the beneficiary. The successor owner is the person who receives the policy if the insured dies but the policy does not pay out.
The third option is to name the trust as successor owner. In that case, the policy belongs to the trust. The trustee then could transfer it to the child as part of the child’s share (if the child wanted it at the time) or cash it out and split the cash among all beneficiaries. The difference with this option (as opposed to the second option) is that the cash value belongs to all beneficiaries, not just the insured child.
The final option is just to cash the policy out.
Our Recommendation
Our standard recommendation in this situation is that if the child is an adult, the client transfer the policy now. In most cases, the policy is relatively small and has served its purpose, and our client no longer has any financial need or use for it. At that point, it is usually best to let the child decide whether to keep it and be responsible for it going forward.
In cases where the insured child is a minor, we generally recommend adding the trust as successor owner. This can always be changed once the child is an adult but doing this avoids probate if the client unexpectedly passes away.
Naming the insured child as successor owner can be a good option when the parents want to hold onto the policy for some reason (sometimes because they want to pay the premiums and keep it going) but want it to go to the child if they pass away.
If the policy has served its purpose but the client believes a transfer would be unfair for some reason, cashing the policy out will be the best option.