Adding Life Insurance Trusts to Your Estate Planning Strategy

Life insurance used to be a standard part of almost every Estate Planning Strategy. In recent years, insurance moved to the back burner or completely off the menu of many estate planning strategies. A recent article in The Wall Street Journal pointed out that the very wealthy make up the bulk of current permanent life insurance owners.

New trends mean it’s time for more people to reconsider the role of permanent life insurance in their estate plans.

Most people purchase term life insurance in their early and middle adult years to handle specific expenses in case of their premature demise. This fairly inexpensive insurance can cover family living expenses, education, mortgages and other debts, and other costs. The term insurance is allowed to lapse as you go through life and many of these expenses are paid or you build enough wealth to cover them. The term insurance no longer is needed.

Permanent insurance, such as whole life and universal life, is for wealth building or for expenses that don’t go away over time. The most common use of permanent life insurance is to pay estate taxes. But other needs can be met by permanent insurance. It can pay debts. Some people use it instead of long-term care insurance to pay for medical and long-term care expenses they accumulate.

Creating or enhancing a legacy is perhaps the fastest-growing use of permanent life insurance in estate planning strategies now and reason to consider adding it to your plan. Changes in the investment markets and in retirement plans are spurring the new interest in life insurance.

When investment markets were strong, many retirees were confident they would leave substantial assets for their loved ones without using life insurance. Their retirement funds earned income and gains at a faster rate than they were spending. I used to routinely run into people who said after 10 years or more of retirement their net worths were higher than when they first retired.

Those days are largely gone. Negative long-term stock market returns and historically low interest rates mean it is takes a lot of work to make a nest egg last through retirement, let alone leave a substantial amount behind. Low investment returns also mean your money could generate a much higher payoff through insurance premiums than traditional investments. Thousands of dollars of premiums over the years can generate a benefit of many thousands of dollars for heirs.

Estate taxes are likely to be a concern of more people in coming years, and some of them will look to life insurance to pay the taxes. There’s no estate tax in 2010, but there’s going to be one in 2011 and future years. We won’t know who’ll pay estate taxes until Congress gets its act together, if it does. It could be estates as modest as over $1 million will owe estate taxes, or $5 million could be the threshold. In any case, more people will have to worry about estate taxes than do today.

When considering life insurance, a married couple should consider a survivorship or joint life policy. The pay off from the premiums from these policies can be quite high. The policy doesn’t pay benefits until both spouses have passed away, so the premiums are lower than for a single life policy. Buy the policy when you are young enough, and the return on your premiums paid can be anywhere from five to one to 20 to one. The exact pay off ratio will depend on the ages and health of you and your spouse.

When you buy permanent life insurance to leave a legacy for your loved ones, there is less pressure on you to control spending and increase investment returns on your portfolio. The insurance premiums are part of your annual expenses, and you know they are taking care of the future of your loved ones.

The best way to buy permanent life insurance to leave a legacy often is to use an irrevocable life insurance trust. If you own the policy, it will be included in your estate for tax purposes, potentially subjecting the benefits to estate taxes. When the trust owns the policy and the policy benefits re paid to the trust, the benefits are out of your estate. But the trust must be irrevocable, and you can’t be a beneficiary. Your children or other loved ones you want to receive the wealth should be the beneficiaries of the trust.

Also, the trust needs a Crummey clause. This states that trust beneficiaries can withdraw any gifts made to the trust within a fixed time period after the gift, usually 30 days. The beneficiaries must be notified each time a gift is made to the trust and reminded of their right to withdraw the money.

The Crummey clause qualifies gifts you make to the trust for the annual gift tax exclusion. You can give $13,000 per beneficiary to the trust free of gift taxes. If you’re married, you and your spouse can jointly give $26,000 per beneficiary annually. That should buy a lot of life insurance. These gifts means you can’t make additional direct tax-free gifts to the beneficiaries. If you don’t have a Crummey clause, gifts to the trust won’t qualify for the annual gift tax exclusion.

You also can draft the trust agreement to control how the eventual benefits are paid to the beneficiaries. You can have beneficiaries simply paid their share of the benefits shortly after the trust receives them. Or the trust can retain and invest the benefits until the beneficiaries reach certain ages or other conditions are met.

The idea of using permanent life insurance to pay estate taxes or create wealth for your heirs may appeal to you, but not the idea of using a trust. Trusts can be expensive and time-consuming. There are alternatives to a trust that also keep the insurance benefits out of your estate.

When the life insurance primarily is to benefit your spouse, he or she can own the policy outright. Be sure you have no ownership interest in the policy (you can make gifts that are used to pay the premiums) and are not a beneficiary. Your spouse can receive the benefits, and they won’t be in your estate.

The insurance can be owned by a partnership in which the partners are your children or the other beneficiaries of the policy. Or the children can own the policy themselves. You give them money to pay the premiums. Again, you can’t have any ownership interest in the policy or be a beneficiary. The potential disadvantage of these two estate planning options is reduced control. This isn’t a problem when you trust the children to use your gifts to pay the premiums. You also should be confident they won’t fight over or squander the benefits.

In recent years the wealthiest Americans were the main users of permanent life insurance in their estate planning. More of the rest of us should take a look at the policies and consider whether they should have a role in our estate planning strategies.

RW November 2010.