Blueprint for Wealth
Wayne M. Zell, Esq.
Life Insurance Trusts Make Good Sense
Life insurance is an important tool in your financial and estate planning. It provides liquidity for loved ones after you die and can be structured to satisfy various financial planning goals and needs. While generally not subject to income tax on death, life insurance proceeds are included in your taxable estate unless you create a properly structured irrevocable life insurance trust to own and administer the policy. In 2012, if your entire estate is worth more than $5.12 million, any value over that amount (including life insurance proceeds) is subject to tax at 35 percent. After 2012 if Congress does nothing to change the laws expected to take effect on January 1, 2013, amounts over $1 million will be taxed at rates of up to 55 percent. The prospect of your heirs paying significant estate taxes on the insurance proceeds makes a compelling argument for using a life insurance trust.
A properly structured irrevocable life insurance trust is designed to collect the proceeds of life insurance from a term insurance, permanent insurance or second-to-die policy for the benefit of your spouse, children and/or future generations without incurring federal or state transfer taxes. In addition, the insurance proceeds can be made available to replace funds used by your estate and trusts to pay any estate taxes arising upon the surviving spouse’s death. Other advantages of creating an irrevocable life insurance trust are that: (1) the proceeds can avoid the claims of the creditors of the insured or the trust’s beneficiaries; and (2) the proceeds may not be subject to the insured’s spouse’s elective share right.
The primary disadvantage of having a life insurance policy held by an inter vivos irrevocable trust (i.e., an irrevocable trust created during your life) is that the insured may not retain the power to modify the interests of the trust beneficiaries. In addition, the insured must be willing to relinquish control of the assets transferred to the trust. Finally, the insured must not need to retain any economic benefit in the life insurance policy and must be able to transfer all such benefits to the trust. For example, the insured generally will not be able to retain the right to cash in or borrow against the cash surrender value of any life insurance policy after it is transferred to the trust, although there are advanced planning techniques to minimize these perceived obstacles.
To avoid being included in your taxable estate, the irrevocable trust must own and be the beneficiary of the insurance policy. Although you can retain the right to replace the trustee of the trust, you should not serve as trustee of the life insurance trust and you should not be a beneficiary of the trust. This avoids the arguments that you retain control over the policy and retain the right to enjoy the insurance policy proceeds, both of which would cause the proceeds to be subject to the estate tax.
Even though your trust owns the policy, you can indirectly pay the premiums on the policy by contributing amounts to pay the premiums to the trust as gifts. Your trustee then notifies the trust beneficiaries that a gift has been made to the trust and gives the beneficiaries the right to withdraw the annual gift for a period of 30-60 days. By granting this Crummey right of withdrawal, the gift is deemed by the IRS to be completed and therefore qualifies for the annual gift tax exclusion of up to $13,000 per person. If you give more than $13,000 per person, the excess gift is subject to gift tax or is offset by your lifetime gift tax exemption (i.e., which is $5.12 million in 2012 and drops to $1 million in 2013). If you transfer an existing life insurance policy to an irrevocable trust, you have to survive for at least three years to avoid having the insurance proceeds included in your estate. Alternatively, you can purchase a new policy inside the trust and avoid the three-year waiting period.
There are several variations on the life insurance trust theme. For example, you can set up a trust that is accessible to your spouse and still avoid estate tax on the life insurance proceeds following both of your deaths. In that event you need to be very careful in how you structure and administer the so-called “spousal access” trust to prevent estate tax inclusion. In addition, there are ways of structuring life insurance trusts to gain current access to cash surrender value building in the trust using so-called private split dollar loan arrangements. Again, the use of this technique involves great care and planning. To learn more about and properly implement life insurance trusts and other advanced estate planning techniques in all their permutations, you should work with an experienced estate planning attorney. One size definitely does not fit all situations, particularly when dealing with life insurance trusts.