Irrevocable Life Insurance Trusts: Reducing or Eliminating Estate Taxes

What is the purpose of an irrevocable life insurance trust?

Contrary to popular belief, life insurance proceeds are a part of the taxable estate. An irrevocable life insurance trust is a powerful technique which removes the proceeds from your taxable estate and allows you to reduce, or in some cases, eliminate estate taxes. Therefore, more assets will be distributed to your beneficiaries.

What are estate taxes?

Federal estate taxes are costly. Estate taxes start at 37% and quickly go up to 55%. Estate taxes must be paid within nine months after you die. If an estate has insufficient cash, assets often have to be liquidated to pay the estate taxes. An irrevocable life insurance trust can be an answer to liquidity problems.

Do you have to pay estate taxes?

Generally, distributions to a surviving spouse are not subject to estate taxes because there is an unlimited marital deduction for both federal and Wisconsin purposes. Typically, the estate tax hits when the second spouse dies. At that time, your estate will pay estate taxes if the net value is more than the exempt amount allowed at that time. The following is the current schedule.

How does the irrevocable trust reduce estate taxes?

You do not own the insurance policies - the irrevocable insurance trust owns the insurance policies. Since you don't own the insurance, it is not included in your estate; therefore, the estate taxes are reduced or eliminated.

EXAMPLE: Assume you are married with a total net estate of $5,000,000, $500,000 of which is life insurance. With a well drafted revocable living trust, you can protect up to $4,000,000 (in 2006, 2007 and 2008) from federal estate taxes. However, your estate would have to pay $460,000 in estate taxes on the amount above $4,000,000. If the $500,000 of life insurance had been placed in an irrevocable life insurance trust, your family would save $230,000 in federal estate taxes.

How does the irrevocable life insurance trust work?

An insurance trust is similar to a triangle and has three roles. The donor (or grantor) is the person creating the trust - you. The trustee is the individual or institution you select to manage the trust. The third component is the beneficiary or the beneficiaries - you will designate who receives the trust assets after you die.

The trustee purchases the life insurance policy. You are the insured and the trust is the owner and beneficiary of the policy. The trustee follows the directions you have provided in the trust. With the insurance trust as beneficiary, you have more control over distribution of the proceeds.

There are many advantages to the life insurance trust arrangement:

1. Life insurance may be a cheap way to pay estate taxes and other costs.
2. Since the life insurance is no longer a part of your estate, you are reducing or eliminating the estate taxes.
3. Life insurance proceeds are liquid. Therefore, other assets such as stocks or investments may not have to be sold to pay estate taxes.
4. Your surviving spouse can receive the income (and principal, if needed) from the trust assets.

You may not be the trustee of the insurance trust. You may name adult children as trustee(s) - special care must be exercised in this selection because many children will not have enough time or experience to act as trustee. The job of trustee is critical. If the appropriate steps are not taken by the trustee each year, the IRS may bring the life insurance back into your taxable estate. The rules are strict and unforgiving. Many individuals appoint an independent individual or a corporate trust company as trustee.

How does the trustee get money to purchase the life insurance policy?

The money comes from you. You will send funds to the trustee to pay the premium. If you transfer money to the trustee, there could be gift tax. However, you can take advantage of the annual exclusions for gift tax up $12,000 per year ($24,000 if your spouse joins in the gift).

Rather than making the gift directly to a beneficiary, the funds given to the trustee constitute the gift. The trustee notifies each beneficiary that a gift has been received on his or her behalf and unless the beneficiary elects to receive the gift now, the trustee pays the life insurance premium. This is referred to as a Crummey notice. Of course, the beneficiaries should understand that it is to their advantage not to take the gift now. Provided these steps are followed, the life insurance proceeds will not be considered as part of your taxable estate.

Is any of this necessary if estate taxes are repealed?

There are many reasons the irrevocable life insurance trust will still play an important role in planning. First, there are serious doubts whether the repeal will ever take place. In addition, this repeal is for federal purposes. It is very likely that Wisconsin will keep an estate tax in place.

Conclusion

The irrevocable life insurance trust offers the benefits outlined in this brochure:

• reduce or eliminate estate taxes
• provide cash to pay estate taxes
• provide control over insurance proceeds

There are other potential uses for this trust as well. For example, many individuals wish to incorporate charitable giving into their estate plan but do not want to reduce distributions to other beneficiaries. If you utilize an irrevocable life insurance trust, you could make charitable contributions from your other assets and thereby reduce your estate taxes. The proceeds from the life insurance trust replace the funds distributed to charities. You reduce estate taxes, give to charity, and still give your other beneficiaries the same distributions (or more) by supplementing your estate with irrevocable life insurance trust proceeds. It is critical that you review your situation with your attorney prior to taking any action.