After the 2001 tax law began a phaseout of the estate tax, many people concluded there was no longer a reason for life insurance and insurance trusts to be considered as part of an estate plan. Yet, there always were reasons to consider life insurance in plans, and there might be new reasons in the near future.
The most frequent reasons to use life insurance are to pay estate taxes and debts. The number of estates paying taxes declined after the 2001 reforms. Yet, those changes expire at the end of 2010, and it isn’t clear the actions, if any, Congress will take. Some want to eliminate the estate tax; others want to keep it in place.
Another traditional use of life insurance is to replace future income to provide for survivors. Life insurance also can increase the size of an estate. For many people, the life insurance benefits will increase the estate more than investing the premiums would.
There are a host of reasons to include life insurance in a plan. Whatever the reason for buying it, the insurance usually should be owned by an irrevocable life insurance trust.
If the insured person also owns the life insurance, the insurance benefits are included in that person’s estate. This will increase the size of the estate and could cause part of the benefits to be siphoned away in taxes. Estate taxes on the benefits are avoided if the irrevocable trust is the owner of the insurance. After the insured passes away, the benefits are paid to the trust. The trustee uses them as directed in the trust agreement.
In the standard arrangement, the insured creates a trust that is permitted to buy insurance on the creator’s life. The insured makes gifts to the trust, either a lump sum or annual gifts, that are used to pay premiums on the policy. The trustee might be directed to do several things with the insurance benefits once received. They could be invested and used to support the surviving spouse. The benefits might be used to pay estate taxes or debts of the estate. Or the proceeds are all or part of the inheritance of the children. Insurance benefits are free of income taxes. If a trust is used to avoid estate taxes, the children receive the entire insurance benefit without dilution by any taxes.
Annual gifts to the trust to pay the premiums can qualify for the $12,000 annual gift tax exclusion if the trust has a Crummey clause. Under this clause, the beneficiaries are entitled to withdraw their shares of the annual gifts within a time frame, usually 30 days after the contribution. If the right to withdraw is not exercised, the gift remains in the trust and no longer can be withdrawn. The trustee will use it to pay the insurance premiums. Without the clause, the gifts do not qualify for the annual exclusion. They either use part of the lifetime gift tax exclusion or are subject to gift taxes if the lifetime exclusion is exhausted.
The insurance trust also can become a dynasty trust in which the insurance benefits are invested to last for generations. A portion of the annual income and gains are distributed to the children and grandchildren before any principal is distributed. We have covered dynasty trusts in detail in past visits.
An insurance trust ensures a person or couple that there will be an adequate inheritance even if they spend all their savings or engage in some speculative investments. It can keep retirees from reducing their standards of living simply to ensure that their loved ones have an inheritance.
A common estate planning mistake is failure to provide adequate liquidity for the estate. Many people underestimate the cash needs of their estates to pay debts and taxes plus the other expenses. Too often, people believe that if they have an adequate net worth there won’t be any cash problems. Yet, taxes, debts, and other expenses must be paid. In addition, the terms of the will might anticipate that at least some heirs receive their bequests in cash. But the estate might not have enough cash to make all these payments. As a result, the estate might have to sell assets to meet obligations, and assets might be sold at less than an optimum price.
For example, suppose Max Profits dies with a $3 million net worth, but $2.5 million of that is in an IRA. The IRA essentially is the only source of cash. To spend cash from the IRA, however, the estate has to take a distribution and pay income taxes on it. The estate might be able to spend only 60% of each dollar it takes from the IRA.
Life insurance can provide cash for estate obligations and avoid fire sales and other actions estates often take to raise cash.
An irrevocable life insurance trust can be enhanced for a married couple if the trust purchases a joint and survivor or second-to-die insurance policy. This type of policy insures the lives of both spouses and pays benefits only after both spouses have passed away. Because two lives are insured, the premiums will be lower than for two separate policies. The discount can be around 40%. The use of a joint and survivor policy can make an irrevocable life insurance more affordable.
To avoid estate taxes, the life insurance trust must be irrevocable. The insured and the trust creator cannot have any incidents of ownership of the policy and cannot have access to gifts contributed to the trust or to the cash value of the policy. The creators must ensure that they have adequate assets outside the trust and will not need access to the trust. The trustee should be independent of the insured. If the trust is not irrevocable or the insured has control over or access to the trust, the insurance proceeds will be included in his or her estate.
There are alternatives to the irrevocable insurance trust. One alternative is to have the children own the insurance policy directly. Gifts to the children can be used to pay the premiums. If the children are owners and exercise all the control over the policy, the benefits will not be included in their parents’ estates.
There can be downsides to this approach. Sometimes the children decide not to pay the premiums and let the policy lapse. Other times they borrow against the cash value, reducing the benefits eventually available. Another potential problem is that after benefits are paid they might not be used as intended, such as to pay the estate debts or taxes. Also, without a trust the wealth is less likely to be preserved and maintained for future generations.
Another option is to have the insurance owned by a partnership. This might provide additional flexibility for the heirs. Yet, the partnership strategy has not been around as long as the trust, so the law is less developed.
The trust ensures that the insurance proceeds are free from creditors of the beneficiaries. That would not be the case if the children own the policy and also might not be the cash with a partnership, depending on local law.
Declining premiums make insurance more affordable than 10 years ago. People who have not considered life insurance and irrevocable trusts as parts of their estate plans should review that decision.