Life Insurance Trusts.
Life insurance can be a valuable tool for estate planning purposes, provided that you properly structure the way in which it is owned and administered. The most efficient way to handle life insurance is through an irrevocable trust. This article addresses the most common misconceptions and explains how this type of trust can save time and provide your heirs with tax free money at the time they will need it the most.
Is life insurance taxable?
Life insurance is part of your taxable estate! The entire face value of your policy is included in computing the fair market value of your estate as of the date of death. If you possess what are called Incidents of Ownership, such as the right to change beneficiaries, the Internal Revenue Service will impute ownership to you even if the policy is not held in your name. If you are considered the owner, and your estate exceeds the applicable estate tax deduction, approximately half of the life insurance proceeds will go to the federal government for estate taxes.
How life insurance can be used
Life insurance can be used in estate planning to either increase the total value of your estate, or to create cash when your heirs need it for living expenses, costs of administration and taxes. Estate taxes are due nine months after the date of death, and the IRS only accepts cash. If your estate consists of real estate or stock, your heirs may not have enough time to sell assets by the due date. Market conditions may not be favorable. Life insurance can create the necessary cash liquidity so as to prevent a forced sale of assets. Life insurance can also be used to create a cash estate necessary for the support of your dependents.
Creating an Insurance Trust
One of the strategies to minimize estate taxes is to have assets held outside of your estate. While this can be as simple as making gifts to others, another technique is to create an irrevocable trust to acquire and own property, such as life insurance policies. Although the beneficiaries of this trust may be the same as those designated in your estate plan, it is treated as the owner of life insurance for purposes of estate taxes. This means that your heirs will receive the insurance proceeds tax free!
How it works
First, you create a written trust document appointing an independent trustee. Next, you use the annual gift exemption of $11,000 per recipient to purchase either a life insurance policy on yourself, or for married couples, a Second to Die Policy which pays upon the death of both spouses. For those who have a net worth that would have been subject to estate taxes, the annual gifts use money, half of which would have been paid for taxes anyway. This is like using matching funds from the federal government!
When the life insurance pays off, the trustee will then administer and distribute those funds in the same way that you have directed. While you are not allowed to require that the money be used to pay your estate taxes or administrative expenses, the insurance trust can buy assets from your estate at their fair market value. This has the practical effect of converting fixed assets to needed cash.
Conclusion
Be smart about how you own life insurance. Since it’s a taxable asset, make sure that your estate is either entirely exempt, or consider using an insurance trust as a way to provide for needed cash for your loved ones while avoiding all taxes.
By Christopher C. Jones © October 2003
