Using Life Insurance to Fund a Special Needs Trust

by: J. Patrick Collins, CFP® , EA

Often times I meet with clients who have created a Special Needs Trust (SNT) and therefore think that the planning stops there.  Unfortunately, creating the trust is just half the battle.  The next item to consider is how you are going to fund it.  One of the most popular vehicles used to fund a SNT is a life insurance policy.  While there are numerous other issues to consider when funding a trust, we are going to focus on life insurance for the purpose of this article.

Life insurance provides a payment of a specified amount at the insured’s death, thereby allowing the insured to transfer the risk of dying prematurely to an insurance company for a certain cost (premium).  Why is life insurance such a valuable tool in special needs planning?  It can create an estate, or lump sum, where none exists.  If a parent determines that their special needs trust must be funded with $500,000 at their death (determining that amount is a whole other article), and they only have $50,000 in assets, there will be a shortfall if they die tomorrow.  While they may eventually accumulate enough assets to fund the trust, there is a major risk if they die prior to accumulating the assets needed.  As shown by the chart below, if this individual would pass away prior to age 90, there would be insufficient personal savings to provide for their child with special needs.

There are two broad types of life insurance:  term and permanent.  Term insurance is a form of life insurance in which the death benefit is payable in the event of the insured’s death, during a specified period, and nothing is paid if the insured lives beyond that period.  Sometimes I equate it to renting a house.  As long as you pay the rent, you can stay in the house.  Similarly, as long as you pay the premium, you have life insurance coverage.  The downside to term insurance is that it becomes extremely expensive as you get older and therefore is a poor choice to fund a SNT.  Term insurance is an excellent alternative for families that are looking to protect an income for a specified period, but if you need the policy to stay in force for your lifetime, term is not a wise choice.

Permanent insurance has two components:  a cash value and cost of insurance.  For each premium you pay, a percentage goes to pay the cost of keeping you insured, and a percentage goes towards the cash value of the policy.  Using the house analogy, this is more like owning, since you are building equity (cash value) in the policy.  Most permanent policies can be designed to guarantee a level premium payment you will have to pay to keep the policy in force over your lifetime.  Because of the way these policies are structured, they are typically the better choice when funding a SNT.  As you might guess, these policies are more costly than their term insurance counterparts because of the guarantees and cash value buildup.

Unfortunately, the insurance industry has gotten a bad name, and in many cases, rightfully so.  Most insurance salesmen earn a commission for the products they sell.  No product sales, no commission.  So, when you walk into their office and they recommend a policy to you, it’s hard to determine if it is in your best interest, or if they just need to make their mortgage payment for that month.  We always advise individuals to seek out a fee-only financial planner, who does not accept commissions, but charges an hourly or fixed fee.  These planners can not only evaluate the myriad of choices surrounding insurance, but can also help you integrate the special needs plan for your child with your personal financial plan.   

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.