A spendthrift clause regulates a beneficiary’s access to the assets or funds from a life insurance benefit. A spendthrift clause can be directly in some life insurance contracts or you can separately set up a spendthrift trust. Both options have the same end goals, paying out your life insurance benefit in installments over a period of time.
We will cover how a spendthrift clause works, the difference between the clause in a contract vs. a trust, and when it may make sense to use the spendthrift provisions.
Key Takeaways:
- A spendthrift clause on life insurance disburses your benefit in installments over a period of time.
- Spendthrift clauses are offered on some life insurance policies with some being set by the insured and others being chosen by the beneficiary.
- A spendthrift trust is a separate legal entity that you set up to receive the insurance benefit and the designated trustee is legally required to disburse the funds based on the plan laid out in the trust documents.
- There are many reasons to use a spendthrift clause to protect the beneficiary from themselves & creditors, or to ensure the money lasts for a specified amount of time.
A Spendthrift Clause In Life Insurance Policy
A spendthrift clause is included in some life insurance policies. It is intended to protect the beneficiary from creditors or their own reckless spending by paying the policy proceeds as periodic income instead of as a lump sum.
Depending on your policy, you may be able to pre-select this option or the beneficiary is allowed to select it when they inform the insurance company of the insured’s death.
When a life insurance benefit is paid out as a settlement, it converts the lump sum into an annuity. Depending on the insurance company, you may have significant flexibility in selecting the term of the payout, from 5-years to lifetime.
This helps protect the insurance proceeds from creditors.
The reason this works is because under a spendthrift clause, the insurance company is technically the owner of the assets and acting as an asset management company. Since the total benefit is owned by the insurer, it is not subject to the beneficiary’s outstanding debts.
However, creditor protection by life insurance varies from state-to-state so you need to do your own diligence on what works for you.
Spendthrift Trust With Life Insurance
If your life insurance policy does not provide a spendthrift clause, or if you prefer more discretion over the proceeds, you can set up a spendthrift trust. A spendthrift trust is a type of trust that is designed to accomplish a similar goal as a spendthrift clause – to protect the life insurance payout from creditors.
This can be an important estate planning tool that allows for you to direct funds in a way that is better suited for your beneficiary.
With a spendthrift trust, you have the trust be the beneficiary of the life insurance payout. Then the trust is the sole owner of the assets and the assets get disbursed incrementally based on any rules you set up.
Spendthrift trusts can be revocable or irrevocable and have many elements that are standard among trusts, such as:
- A grantor who establishes the trust (this would be you)
- A trustee who manages the trust (this can be a designated person or an asset management company)
- A beneficiary or beneficiaries that receive the assets held in the trust
- Trust documents which define any rules around disbursements
The trustee is legally obligated to follow the rules laid out in the trust.
Other Benefits of Spendthrift Clauses For Life Insurance
Preventing creditors from getting your death benefit isn’t the only reason to consider spendthrift clauses. They can also be used to safeguard your money from a beneficiary who may not be financially responsible.
If your heirs struggle with addictions, gambling, or just don’t have sufficient self-control, you can use spendthrift clauses and trusts to ensure the inheritance is slowly drawn down.
Additionally, if one spouse handled all the finances and you don’t want to burden your partner with managing money, you can establish an income stream so they don’t need to worry.
Spendthrift Trusts and Taxes
Unfortunately, trusts may have tax liabilities under the Federal Income Tax Code on Estates, Trusts, Beneficiaries, and Decedents. The designated trustee is responsible for filing an income tax return and paying any taxes owned on the earned income.
Consult your tax advisor or estate planner for your own personal situation.
Example of Spendthrift Payouts
If you planned to leave $1,000,000 to your beneficiary and want to ensure the money lasted for 20 years. You could use either a life insurance spendthrift clause or a separate spendthrift trust.
Let’s say you settle on equal monthly increments for 20 years, or 240 monthly payments. The benefit would be paid out as $4,167 each month over 20 years.
[Professor B.T. Effer Note – In actuality, the money would earn some interest and the payments could be slightly larger, but we ignore that for the example.]
Managing a $4k monthly payment is easier than managing a $1 million windfall. Additionally, you can take solace that the money will last the full 20 years and not be spent too soon.
Also note, in a trust, you can have even more discretion. Maybe you want 1/4 of the money paid out at age 22 (to pay off college), 1/4 at age 25, and the rest at 30. You can get as granular as you want.
The Final Word
Spendthrift clauses are a great addition to your life insurance. They are a huge benefit in helping you rest easy knowing your estate will last. Life insurance is an important piece of your personal financial portfolio and the key component of the protection group under the 5 pillars of personal finance.
But, life insurance can be confusing, especially with all the legal descriptions in the large policy documents.
We know.
And adding additional restrictions can further complicate the situation. It is best to work with an estate planning lawyer to help set up the trust properly and to navigate the legal process and jargon. But understanding your policy’s features better can help you plan so your life insurance accomplishes its purpose – helping protect your loved ones.
Frequently Asked Questions (FAQs):
A spendthrift clause allows you to better control the disbursement of your life insurance policy by paying out the benefit in installments instead of as a lump sum. By paying out your benefit in installments over a certain period, you can help ensure your estate lasts, protect the inheritance from creditors, and ease the financial burden of managing a large windfall.
Some life insurance policies offer a spendthrift clause in the contract. This allows either the insured or the beneficiary to opt into receiving the benefit in installments. The money that isn’t disbursed is technically owned by the insurance company which protects it from creditors.
A spendthrift trust is a separate trust you set up to receive your insurance benefit. You assign a trustee (either an individual or an asset management company) to manage the money and disburse it to the beneficiary on a predetermined schedule.
Both options are similar, but a trust requires more work and allows for more granular instructions.
There are many reasons to use a spendthrift clause. Some of the common reasons are:
1) To protect your insurance benefit from your beneficiary’s creditors
2) To ensure your money lasts a specified period of time
3) To protect your benefit from being recklessly spent
4) To make the payments into more manageable sizes
Spendthrift clauses are specifically designed to protect the beneficiary from themselves and their creditors. Assets held in the spendthrift clause (either by the insurance company or a trustee) are not owned by the beneficiary until disbursed.
The trust is a separate legal entity that may incur tax liabilities under the Federal Income Tax Code. The owner of the assets must file an income tax return on behalf of the trust.