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The Tax-Free Life Insurance Trust – An Estate Planning Strategy

Last update on: Jul 23 2020
Estate Planning

There’s a big down-side to the boom in stocks and other financial assets. When the value of the assets you own goes up, so do potential estate and gift taxes. If you don’t  adjust your estate planning and take action, the IRS could end up with more of your estate than your loved ones. One easy way to handle the estate taxes is to set up an irrevocable life insurance trust.

You give money to the trust each year, which the trustee uses to pay for insurance on your life. After you pass away, the insurance benefits are paid to the trust and are not considered part of your taxable estate.

When the insurance trust is set up properly, the first $10,000 of annual gifts per beneficiary are exempt from gift taxes ($20,000 if you and your spouse give jointly). If you have two children who are beneficiaries of the trust, you can give up to $20,000 per year to the trust gift-tax free. You and your spouse can give $40,000 jointly.

But gifts above those amounts use up part of your lifetime estate and gift credit or incur gift taxes. With estates climbing in value, the annual gift tax exemption often isn’t enough to pay for the permanent insurance policies many people need to cover their potential estate taxes. And those using the trust cannot make other gifts tax free to their loved ones. The insurance premiums exhaust the tax-saving options.

But there’s a creative new strategy that can meet all your goals. The family split dollar trust allows you to make higher tax-free contributions to the trust and still keep the insurance proceeds out of your estate. It also is called the private split-dollar trust. Here’s how it works.

You create an irrevocable trust, with someone other than you or your spouse as trustee. Your children or other loved ones are beneficiaries. The trustee uses your initial contributions to the trust to buy insurance on your life.

Then you enter into an agreement with the trustee stating that the trustee will pay the part of the annual insurance policy premiums equal to one-year term insurance rates. You pay the rest of the premiums. Should the insurance policy or the agreement be terminated, you get the cash value. If the policy remains in force, after your death the trust pays the estate the greater of the policy’s cash value and the sum of the premiums you paid. The rest of the insurance benefits stay in the trust and are paid out according to the terms you set in the trust agreement.

The IRS has ruled that the premiums paid by you are not considered taxable gifts, because you or your estate eventually will be reimbursed for them. Only the portion of the annual gifts equal to the term insurance premiums are potentially taxable gifts. With term insurance rates at record lows, this should be a small amount. And the rest of the insurance benefits are not included in your estate because they belong to the trust.

The bottom line from this arrangement is that you are laying out the same amount of cash each year, but a much smaller portion is using up the annual gift tax allowance. Through the trust you can fund, tax free, a much larger insurance policy than you can under the traditional insurance trust. Family split dollar is ideal for a large estate that is protected by a life insurance policy with annual premiums that exceed the allowable gift tax exclusion.

The family split-dollar insurance trust is very flexible. The agreement with the trust can be made by you, your spouse, or both of you. The trust can purchase a traditional whole life policy or a second-to-die policy covering both you and your spouse.

You can go a step further and use the family split dollar trust to supplement a retirement plan. Here’s how it works.

A business owner sets up the trust with the spouse and children as the beneficiaries.They’ll receive payments from the trustee after the business owner dies.

But this time the spouse and the trustee enter into the split dollar agreement. The spouse pays the cash value portion of the premiums (using unlimited tax-free gifts from the business owner allowed by the marital deduction). That means the spouse receives the cash value if the policy is surrendered or when the business owner dies. If a cash emergency arises, the trustee can cash in the insurance policy and give the cash value to the spouse, with no taxes.

You need an experienced estate planner to set up this arrangement. Be sure your estate planner reviews IRS Private Letter Rulings 9745019 and 9636033. You also should seriously consider incurring the extra cost and delay of submitting your own request for a private letter ruling to the IRS.

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