Yahoo! Life Insurance Trusts: A Way to Save Estate Taxes

Topic - Life Insurance Trusts: A Way to Save Estate Taxes

One of the enduring myths about life insurance is that its death benefits are tax-free. True, the proceeds are free of income tax for the beneficiaries. But those same benefits may be subject to tax in the estate of the insured.

That's the irony of buying life insurance to pay for estate taxes, often a strategy used by those whose gross estate exceeds the tax-free $600,000 limit. The policy proceeds intended to pay the estate tax bill become part of the bill themselves. Let's say you have an estate facing a federal estate tax of $200,000. If you buy a $200,000 life insurance policy to pay the estate tax bill, the proceeds will be added to the total value of your estate, and you'll end up owing at least another $75,000.

One way out of this dilemma is to set up an irrevocable life insurance trust, which takes over ownership of the insurance policy, says Mandell Winter, CLU, ChFC, a senior academic at the College for Financial Planning ^®, a division of the National Endowment for Financial Education ^® (NEFE ^®). "One of the big advantages of a life insurance trust is that it removes the life insurance from the estate of the insured."

The trust also may serve other ends. For example, at the death of the insured, the policy proceeds may remain in trust to provide regular income for the surviving spouse (while keeping the assets out of the spouse's estate). Or the trust may be used to distribute proceeds to children from a previous marriage.

"A life insurance trust can be set up with a great deal of flexibility," says Winter. "For example, the trust can distribute a limited amount of the insurance proceeds over a period of time to a financially irresponsible child. Yet should that child suddenly have need of extra money, the trust can provide additional funds at the discretion of the trustee."

Despite the advantages of an irrevocable life insurance trust, Winter advises anyone thinking about setting one up to keep these points in mind:

It's irrevocable. Technically, life insurance trusts are called irrevocable life insurance trusts, or ILITs. To keep the policy out of your estate, you must give up complete control over it. That means you can't change the beneficiary, cancel the policy, borrow against it, or otherwise alter the terms should circumstances change. You can't even legally compel the trustee (the person managing the trust) to use the proceeds to pay estate taxes. Consequently, the trustee should be someone who is competent and who you are certain will carry out your wishes (usually outlined in written instructions). A common choice is a close friend or a financial institution, but someone who is not a beneficiary.

The insurance can come back to your estate. If you transfer a policy into a life insurance trust, but die within three years of that transfer, the policy ownership reverts to your estate and the estate pays tax on the proceeds. One way around this risk, says Winter, is to have the trust buy a policy on the insured's life.

The beneficiaries can spend some of the trust funds. Whether you transfer a policy into a life insurance trust or have the trust buy a policy, you'll need to gift to the trust sufficient funds to pay the premiums. But to meet the gift-tax exclusion rules, you'll have to include what's known as a Crummey provision (named after a court case). This provision allows beneficiaries the opportunity to withdraw their share of the gift, typically within a certain time, such as 30 days. Most financial advisors recommend using the "five by five" rule, meaning that a beneficiary may take the greater of $5,000 or 5 percent of the trust assets as the limiting factor for the amount to be withdrawn. Obviously, if they do withdraw funds they've defeated the purpose of the trust.

Trusts cost money. Beyond the cost of paying for hefty insurance premiums, legal fees for a life insurance trust can easily run $1,500 or more.

In view of these drawbacks and risks, some might argue that it is easier to simply have the beneficiaries directly own policies on the life of the insured and dispense with the hassle of an ILIT. In some cases, this may be appropriate, says Winter. However, he points out that the beneficiaries may not be mature or responsible enough to use the money to pay estate taxes or as otherwise intended by the insured. Also, divorce, bankruptcy, or a lawsuit against a beneficiary may allow access to the policy's cash value or the proceeds by the ex-spouse or creditors. An ILIT would prevent this. Separate policies also are more complicated if several beneficiaries are involved.

The National Endowment for Financial Education is an independent nonprofit institution that advocates standards for all financial advisors and is dedicated to the goal of helping Americans achieve financial well being. Divisions within the NEFE structure include the College for Financial Planning, the Institute for Tax Studies ^®, the Institute for Wealth Managements ^SM, the Institute for Retirement Plannings ^SM, the NEFE Public Education Center, and NEFE Press ^SM. NEFE's latest educational offering is the Chartered Mutual Fund Counselor Professional Education Program. The 24-year-old College for Financial Planning, NEFE's degree-granting division, is accredited by the Commission on Institutions of Higher Education of the North Central Association of Colleges and Schools (NCA). The College for Financial Planning Master of Science degree program also is accredited by the Accrediting Commission of the Distance Education and Training Council.

In addition, other curricula offered by the College for Financial Planning include the Certified Financial Planner ^® Professional Education Program, Advanced Studies courses, Foundations in Financial Planning, the Financial Paraplanner Program ^®, and a broad range of professional development offerings.

COLLEGE FOR FINANCIAL PLANNING, NEFE PRESS, FINANCIAL PARAPLANNER PROGRAM, INSTITUTE FOR RETIREMENT PLANNING, INSTITUTE FOR WEALTH MANAGEMENT, and INSTITUTE FOR TAX STUDIES are service marks of the National Endowment for Financial Education. NEFE and the College for Financial Planning admit students of any race, color, creed, age, sex, disability, and national or ethnic origin. CFP and CERTIFIED FINANCIAL PLANNER are federally registered service marks of the Certified Financial Planner Board of Standards, Inc.

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