Leaving your special needs child with enough money to pay for their needs after you are gone can be a daunting task. The costs of providing a home and care exceed the resources of most families. Often a good solution is to fund a special or supplemental needs trust (“SNT”) with life insurance. A parent can take out a life insurance policy on his or her life to ensure that once the parent is gone, monies will be available to care for the special needs child.
The benefits of funding an SNT with life insurance are many. Life insurance proceeds can be paid to an SNT free of income taxation. Life insurance also typically pays proceeds in a short time period and so can ensure that the special needs child has the cash needed to provide for her long-term care. Further, a paid-up life insurance policy will guarantee an SNT future funding while keeping the parents’ estate intact for other family members.
The various types of life insurance that can be used to fund an SNT include:
Term Life Insurance: Term life insurance provides coverage for a defined period of time, normally the time in which premiums are paid. After that period ends, the policyholder can choose to continue to pay for the policy or end coverage. A term policy pays a benefit should the policyholder die within the period covered under the policy. The premiums for term policies typically increase each year as the insured gets older or are level for a specified number of years, such as 20, after which the policies are typically dropped due to the steep increase in premiums at the end of the guaranteed term.
Whole Life Insurance: Unlike term insurance, a whole life policy lasts for the policyholder’s entire lifetime and provides both death benefit protection and cash value. Part of the premium paid by the policyholder goes into a cash account which accumulates over time. The cash value tends to accumulate at a higher rate when the policyholder is younger and lessens as she ages. Further, many of these policies pay dividends, which add additional value to the policy. Policyholders may withdraw money from their whole life policy but will be charged a fee or, in the case of a loan, the holder will be obligated to pay back the borrowed amount with interest.
Universal Life Insurance: A universal life policy permits the policy holder to adjust death benefits and premium payment to fit any change of circumstances for the holder. Premiums can be credited to an accumulation fund from which premium costs are deducted and to which interest is credited.
Variable Life Insurance: The variable life insurance policy’s cash value is tied to the performance of financial markets.
Survivorship Life Insurance: Also known as a second-to-die life insurance, this policy is taken out on the lives of two people and provides benefits only upon the death of the second insured person.
What type of life insurance is best?
A special needs trust’s need for the insurance benefits is likely to be permanent, so term insurance is not the best option if other types of insurance are affordable. Term life insurance offers lower premiums for a fixed period of time, 10 or 20 years, for example, but when the term expires, the premiums that are charged upon policy renewal are usually unaffordable. Therefore, a whole life policy or universal life policy with a guaranteed death benefit is recommended. The premiums for these types of policies, while initially more expensive than the premiums for term policies, usually remain constant throughout the duration of the policy. Moreover, in many cases, the income that the policy produces by investing the premium payments can pay some or all of the premium after the policy has been in place for a few years.
Many financial planners recommend survivorship life insurance for funding an SNT trust, which means that the funds become available upon the death of the second parent to die, due to the lower cost of the premium, as compared to life insurance on a single life. The policy pays out after both parents have passed away, which is presumably when the child will need the money.
On the other hand, sometimes purchasing survivorship life insurance is not the right solution, because the surviving spouse has to keep paying the premiums after the first spouse dies, which might be a hardship or create uncertainty. In those cases, people should consider purchasing life insurance covering each spouse, with the SNT as the beneficiary. .
Whatever type of insurance policy is chosen, the policy must name the trustee of the SNT, in his or her capacity as trustee, as beneficiary of the policy, rather than naming either the trust itself or the individual with special needs.
Persons with estates large enough to be subject to the federal estate tax (currently estates over $5,430,000) regularly create irrevocable life insurance trusts. Such trusts own, administer, and receive proceeds from life insurance policies purchased in the name of the trust in order to prevent the death benefit from being included in the estate of the insured person for estate tax purposes. While proceeds of an insurance policy are not taxable for income tax purposes, they are taxable for estate tax purposes. A properly drafted, funded and administered irrevocable life insurance trust removes the value of the policy from the taxable estate of the insured person because the policy is not owned by the insured at the time of his or her death.
Such irrevocable life insurance trusts can be coordinated with SNTs by making an SNT the ultimate beneficiary of the irrevocable life insurance trust. (Another option to ensure that the proceeds of the policy are not part of the grantor’s estate is to create an irrevocable SNT, with a trustee that is not the grantor.) A life insurance policy owned by an irrevocable trust should not be considered a disqualifying asset for Medicaid purposes if the insured person requires long-term care him or herself in the future. Such asset sheltering and tax reduction, of course, ultimately benefit the beneficiary of the SNT.
For more information about funding special needs trusts, contact Karen Mariscal.