Irrevocable Life Insurance Trust

Many people do not realize that when they die with the incidents of ownership in a life insurance policy (policies you can borrow against, assign or cancel, or can change a beneficiary or a life insurance policy in their own name or payable to their estate), the entire proceeds are included in their estate for federal estate tax purposes.

Under current law, the net value of an estate over $5,450,000 is subject to federal estate tax before it can be fully distributed to your beneficiaries. This is extremely important for a single person whose estate is close to $5,450,000 or a married couple who does not have tax-planning provisions in the Living Trust or will with an estate of $5.4 million. Death benefits from life insurance are not subject to income tax. Even though these proceeds are payable to a beneficiary, they will be included in your estate for federal estate purposes.

As an example, suppose an individual had $5,450,000 worth of assets including his car, home, stocks, bonds, IRAs, CDs and other investments. This individual also had a $250,000 life insurance policy with the idea in mind that the death benefit proceeds would provide liquidity for his estate to pay any debts and preserve as much of his estate as possible for his children. Unfortunately, he died owning the policy in his own name even though he named his children as beneficiaries. The $250,000 death benefit was included in his estate for federal estate tax purposes and created a $102,500 tax liability (41 to 50 cents of every dollar over $5,450,000 will go to the Federal Government), thus reducing the death benefit to $147,500 on the $250,000 policy.

To eliminate this problem, an irrevocable life insurance trust could be set up. This individual would pay the premiums to the trustee of the trust. The trust cannot be managed by the person making the trust. This normally does not cause problems, particularly if you can save taxes and know who the beneficiaries would be anyway. Because the irrevocable trust owns the policy, insurance proceeds are not included in the estate and the full $5,450,000 estate value plus the entire death proceeds from the insurance will pass to the named beneficiaries free of federal estate tax.

It is even possible to name the irrevocable insurance trust as beneficiary. The advantage to this over naming a child or children the beneficiary is that the trust could delay payment to named persons so that periodic payments could be made. You could even provide your spouse with lifetime income and keep the insurance proceeds out of both of your estates. It is also possible to state that the person who would receive the proceeds, if they became incapacitated, would not receive the proceeds outright so that the proceeds would not be subject to court approval, as is often the case if someone is declared incompetent.

Internal Revenue Code rules must be followed in setting up and funding the irrevocable life insurance trust. It is often preferable to transfer cash to the trustee who will purchase the policies or pay the premium for the beneficiaries. The trustee will notify each trust beneficiary that a gift has been made on his or her behalf and that they have a right to withdraw the gift within a specified time, perhaps 30 days. The beneficiaries will decline, and the trustee will then invest the funds by paying for the premiums.

Existing policies may also be transferred to an insurance trust.

However, if death occurs within three years of the transfer, the death benefits will still be included as part of the estate or will be subject to the federal estate tax.

Life insurance can be an extremely useful tool in the hands of an experienced estate-planning attorney. Insurance trusts are legal documents and they must be drafted by an attorney. Life insurance proceeds often provide liquidity to pay expenses and taxes that are due nine months after death. It may be an important consideration to provide liquidity for small business owners or farmers after the death of an individual to keep the operation going. Certainly, insurance proceeds are leveraged money, i.e.; the death benefit should always exceed the total of the premium paid. Planning, regarding ownership of insurance policies, is very important in making sure that your beneficiaries, rather than the IRS, receives the insurance benefits you are paying for.

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