Under Florida law, life insurance is exempt from the claims of creditors. The exemption is rooted in public policy in the sense that when a person dies and leaves behind life insurance, that insurance is supposed to take care of a spouse and perhaps children. If creditors are first in line for the proceeds, then we might have many widows and children without any funds on which to live.
But sometimes the beneficial creditor protection of life insurance can be jeopardized. This is when the insured’s estate is named as the beneficiary. When your estate is named as the beneficiary to your life insurance policy, now it could be subject to the claims of your creditors since it is a probate inventory asset.
Allow me to provide an illustration of how this problem may arise:
Lisa owns a $500,000 life insurance policy on her life. She has two minor children. Knowing that minor children would need a court-appointed guardian to collect her life insurance, Lisa names her estate so that her personal representative could collect the life insurance proceeds at her death, and then hold those proceeds in a testamentary trust created under her will for the benefit of her two minor children until they become adults. When Lisa died, she had many medical bills that weren’t covered by insurance. The hospitals and physicians filed claims against Lisa’s estate, thereby consuming a good portion of the life insurance that Lisa otherwise intended to benefit her children.
The problem may also arise in another sense. Assume, for example, that Lisa never named a beneficiary to her life insurance. The default beneficiary under the life insurance contract itself is often the insured’s (Lisa’s) estate. This happens more often than one would imagine.
So what should you do when you wish to name minor children as beneficiaries to a life insurance policy in order to keep the creditor-protected character in place? The best way to deal with this issue is to create a trust that would become the beneficiary of the life insurance policy. The trust would then include the minor children as beneficiaries. Here, the trustee of the trust would be able to collect the life insurance proceeds, and distribute those proceeds creditor-free to the beneficiaries.
If the trust you create is irrevocable, then you have what is known as an Irrevocable Life Insurance Trust (ILIT). In order to qualify the contribution of amounts to the ILIT in order to pay the premiums as gift tax free under the $14,000 annual gift tax exclusion amount, the beneficiaries must be given a “Crummey withdrawal right”. Generally speaking, after you contribute the amounts to the trust to pay the premium, the trustee must provide the beneficiaries (or their legal guardian) a 30 day window to withdraw their share of the contribution. The beneficiaries don’t exercise that right usually, since to do so would thwart the payment of the premium and consequently the policy would lapse.
You don’t necessarily have to create an ILIT in order to protect the insurance benefits. This may be accomplished through a revocable living trust, although you should work closely with your estate planning attorney to ensure all of the proper elements are drafted into the trust to provide the proper protection, and that the life insurance policy’s beneficiary provisions are properly completed.
Many of these same issues come into play when you leave life insurance to disabled beneficiaries or to beneficiaries that would squander the money. For those you will likely need a testamentary trust of some kind with a gatekeeper trustee.
The bottom line is to let your estate attorney know about any life insurance that you might own, especially if you have minor or other beneficiaries with special considerations.