IRREVOCABLE LIFE INSURANCE TRUSTS

An irrevocable life insurance trust allows you to reduce or eliminate estate taxes so that you can pass more of your estate to loved ones. For a single individual whose net estate, including life insurance, exceeds the estate tax exemption ($2,000,000 in 2006, 2007, and 2008) and a married couple whose net estate exceeds both spouse’s exemptions ($4,000,000 in 2006, 2007, and 2008), an irrevocable life insurance trust should be considered.

A common misperception is that a life insurance policy is free from ALL taxes. That is not true. The proceeds from a life insurance policy are only free from income taxes to the beneficiary, but ALL assets are taxed by the federal government for the federal estate tax. So, if a married couple has an estate that is valued at $4,500,000 (of which $500,000 is life insurance), they can implement a revocable “A-B” living trust which will protect $4,000,000 from estate taxes. Remember that in 2006 the federal estate tax rate starts at 37% and increases to a peak of 45%. Thus, the excess over the exempt amount will be taxed at a rate starting at 37%. Here, that amount is $500,000, and tax will be approximately $225,000!

If the couple were to utilize an irrevocable life insurance trust to own the life insurance policy, the life insurance proceeds would be removed from the couple’s estate and could completely avoid federal estate taxes. This is because the TRUST owns the insurance policy, not the individual. Therefore, the policy is not included in the person’s taxable estate at death. This means the estate will pay less in estate taxes while the heirs still benefit from the proceeds of the life insurance policy.

Here’s how an irrevocable life insurance trust works. Your estate planning attorney drafts the terms of the irrevocable life insurance trust, and you (and your spouse) name a trustee other than yourself (i.e., bank, corporate trustee, adult children). That trustee then purchases a life insurance policy with the trust as the owner and you as the insured. The amount allowed to pay for the premium is equivalent to the annual gift allowance: $12,000 per year per beneficiary, or $24,000 per year for a married couple. The trustee must advise the beneficiaries of the trust in writing that you (and your spouse) have made a gift to them. It is important to note that legally, the beneficiaries can withdraw their share and use the funds for whatever they desire. However, it is in their best interest not to do so. Assuming the beneficiaries do not withdraw the funds, the trustee may then use the gifted funds to pay for the insurance premiums.

When you pass on, the life insurance proceeds are paid to the trustee, who then uses it to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits). The remaining proceeds are then distributed by the trustee to the beneficiaries of your trust. The proceeds will not be included in your estate when calculating estate taxes because the policy is owned by the trust and not by you. The irrevocable life insurance trust gives you control over how the proceeds are to be used since the trustee that you name will distribute the proceeds according to the instructions set forth by you in the irrevocable life insurance trust.

It is also possible to transfer an existing life insurance policy into an irrevocable life insurance trust, but if you die within three years of the date of the transfer, the life insurance proceeds will be taxed as part of your estate. The transfer may also subject you to a gift tax since the beneficiaries of the trust would be receiving policies with a value in excess of the annual gift tax exemption. You should meet with a qualified estate planning and tax attorney who will properly advise you on the benefits of an irrevocable life insurance trust, and help determine if it is a proper tool for your estate plan.