By Robert S. Jacobson, Trust & Estate Planning (TEP) Practice Group
Few people realize that, even though they may have a modest estate, their families may owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a death benefit that could exceed the current estate tax exemption of 5.43 million dollars. This is because life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax.
The solution to this possible estate tax problem is to create an irrevocable life insurance trust that will own the life insurance policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from any potential future creditors since the assets are held in trust.
Here are the mechanics of the life insurance trust. You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won’t have to pay gift tax on the contributions.
The life insurance trust typically provides that during your lifetime both principal and income, at the trustee’s discretion, may be paid to your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. Upon your death, the trust continues for the benefit of your spouse during his or her lifetime.
Your spouse is given certain beneficial interests in the trust, such as the right to income and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants, tax free.
If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you.