What Are the Disadvantages of a Trust as a Life Insurance Beneficiary?

Naming a trust as a life insurance beneficiary is an estate planning strategy used to provide for minor children, manage assets for an heir, or for complex tax planning. This approach allows the person creating the trust, known as the grantor, to control how and when insurance proceeds are distributed. While this control is advantageous, it introduces layers of legal and financial complexity and several distinct disadvantages.

Increased Administrative Complexity and Costs

Choosing a trust as a life insurance beneficiary introduces administrative layers absent when naming an individual. The initial step requires drafting a legal trust document with an experienced estate planning attorney. A trust is a complex instrument that must be tailored to the grantor’s specific wishes and comply with state laws. The cost for an attorney to create such a document can range from a few thousand dollars to much more.

Beyond the initial setup, the ongoing administration of the trust generates recurring expenses. Once the trust receives the policy payout, the trustee is responsible for managing those assets. If a corporate trustee, such as a bank or trust company, is appointed, they will charge an annual fee, often ranging from 1% to 2% of the assets under management.

The trust is also a separate legal entity for tax purposes, creating another administrative burden. The trustee must hire an accountant to prepare and file a U.S. Income Tax Return for Estates and Trusts, Form 1041, each year the trust has taxable income. Should a dispute occur, the trustee may need to retain legal counsel, further diminishing the trust’s assets.

Restricted Access to Policy Proceeds

A primary drawback for a beneficiary is restricted access to the life insurance funds. When an individual is the beneficiary, they receive the death benefit as a lump-sum payment from the insurance company. This swift process provides immediate liquidity to cover final expenses or other financial needs.

When a trust is the beneficiary, this direct access is lost. The life insurance proceeds are paid to the trust, and the trustee assumes control of the money. The trustee is legally bound to distribute the funds according to the trust’s terms, meaning a beneficiary cannot use the funds for a purpose not explicitly permitted.

Many trusts use specific distribution standards, such as providing for a beneficiary’s “health, education, maintenance, and support” (HEMS). The trustee has discretion to determine what expenses qualify and can deny requests for other purposes, like starting a business or buying a vacation home. The trust might also mandate that distributions are spread out over many years, preventing the beneficiary from receiving a large portion of the inheritance at once.

Potential for Unfavorable Tax Treatment

Life insurance death benefits are generally received income-tax-free, but subsequent income the proceeds generate can be taxed. When held in an irrevocable trust, this income is subject to compressed tax brackets. This means trusts reach the highest marginal tax rate at a much lower income level compared to individuals.

For the 2025 tax year, a trust could hit the top federal income tax rate of 37% on income over $15,650. In contrast, a single individual filer would not reach that same 37% tax bracket until their income exceeds $626,350. This disparity means that if the trust retains income from investing the insurance proceeds, a significant portion could be lost to taxes.

To avoid these high trust tax rates, a trustee can distribute the income to the beneficiaries, who are then taxed at their individual rates. This action is dependent on the trust’s terms allowing for such distributions. Furthermore, certain trusts, like Irrevocable Life Insurance Trusts (ILITs), have their own administrative tax complexities. The trustee must send annual “Crummey notices” to beneficiaries, informing them of their right to withdraw gifted amounts used for premium payments.

Difficulties with Trustee Management

The grantor must choose a trustee who is trustworthy, financially astute, and capable of navigating complex administrative duties. Naming a family member or friend can be problematic, as an individual trustee may lack the expertise to manage investments or file tax returns. They also bear significant fiduciary responsibility and legal liability for their actions.

Appointing a corporate trustee, such as a bank’s trust department, ensures professional management and expertise in administration, investment, and tax compliance. However, beneficiaries may find a corporate trustee to be impersonal and inflexible compared to a family member who better understands the family dynamics.

Replacing a trustee can also be a complicated and expensive process. If a trustee is not performing their duties properly or a conflict arises, removing them may require a court proceeding. The trust document may outline a process for removal, but this can still lead to legal fees and administrative delays.