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Articles & Press Releases

June 28, 2007

Life Insurance in an Estate Plan

Estate Planning - Life Insurance in an Estate Plan

Besides protecting your family from financial hardship, life insurance also can be an estate-planning tool to transfer large sums to your loved ones free of estate tax and at little or no gift tax cost. This can be done using a life insurance trust. Life insurance trusts can have significant current and future use in a wide variety of individual circumstances. In spite of the fact that the Economic Growth and Tax Relief Reconciliation Act of 2001 made substantial changes to the rules governing estate taxation, life insurance trusts remain a viable and valuable estate planning tool.

Life insurance proceeds are subject to estate tax if the insured owned the policy at death, or transferred it within three years of death. Even if the policy was transferred to another, an insured is considered to still own the policy if, for example, the insured possesses any of the following: the right to change the beneficiary, the right to borrow against the policy, the right to surrender the policy for its cash value, or the right to pledge the policy for a loan. In other words, all of these "incidents of ownership" in the policy must be transferred more than three years before death for the proceeds to escape being included in the insured's estate.

If these obstacles are overcome, substantial estate tax savings can be realized by transferring a life insurance policy. But if you give a policy to your spouse who predeceases you, the policy's value will be taxed in your spouse's estate. You probably do not want to give the policy to your children either, unless they are mature and financially secure in their own right.

It's for these reasons that life insurance trusts have become such popular devices. If a life insurance policy and all policy rights are transferred to an irrevocable trust, and the ex-owner survives for the next three years, the policy proceeds can escape estate tax in the surviving spouse's estate as well as the insured's. A trust also provides flexible settlement options. You can have the funds managed professionally, protecting beneficiaries from financial inexperience. The trustee can be given discretion to pay income in varying amounts to beneficiaries depending upon their needs and their tax situations.

It is important to note that the tax act did not change the usefulness and viability of life insurance trusts until 2009, during the estate tax phase-down period. In addition to the advantages described above, life insurance, whether it is held in trust or outside a trust can be used to pay any estate tax due during the period before repeal in 2010. During the year of the repeal-2010-life insurance proceeds, whether held inside or outside of a trust could use to ameliorate the impact of the loss of the stepped-up basis if the estate's beneficiaries want to dispose of assets. And, if Congress takes no action and the current estate tax rules are reinstated in 2011, life insurance trusts will again be just as useful as they currently are.

If you want to set up a life insurance trust, you also have to decide whether it should be funded or unfunded. If the trust is to be funded, you will have to transfer cash or other property to it to pay the premiums on the policy. If it is unfunded, you or someone else will have to make periodic contributions to it so that the premiums can be paid. As with any trust, there are income tax and gift tax consequences that have to be planned for.

The tax-saving opportunities of life insurance trusts are so substantial that some lawmakers have called for their elimination. Nevertheless, insurance trusts have survived the current round of budget balancing and deficit reduction, and if there are any future changes in this area, in all likelihood, they would not apply retroactively. If you are interested in setting up a trust or learning more about this technique, please don't hesitate to call us.

If you found this article of interest and would like to find out how LBO can help you acheive your tax, insurance, and financial planning goals, please give us a call at 631.864.5206, or simply fill out our information request form and an LBO representitive will contact you as soon as possible.