By Rachel L. Sheedy
Your heirs will surely welcome the proceeds from your life-insurance policy. But they probably won't be thrilled by the estate taxes they may have to pay on the death benefit. If your estate is likely to be subject to federal estate tax, you may want to consider stashing your policy in an irrevocable life-insurance trust.
Such a trust will keep the insurance proceeds out of your estate, thus reducing the amount of estate taxes your heirs will pay. Or perhaps the trust lock-box could help your heirs avoid estate tax altogether if the insurance proceeds would otherwise kick your estate over the taxable threshold.
Life-insurance proceeds are subject to federal estate tax if they go to heirs other than a spouse. Until 2009, the top estate-tax rate is 45%. Estates worth at least $2 million are subject to federal estate tax until 2009, when the threshold rises to $3.5 million.
Congress is mulling changes to the thresholds, but it's far from clear what it will do. Without action, the exemption will drop permanently to $1 million in 2011. In light of that, elder-law attorney Don Chapin, of Chapin Law Offices in Dublin, Ohio, recommends that clients consider a life-insurance trust if they expect to have an estate worth about $1 million.
If you set up a trust, you can either transfer owner-ship of your existing policy to the trust, or make contributions so that the trust can buy a policy. In either case, you no longer own the policy, which is why proceeds are excluded from your estate.
A life-insurance trust can provide other benefits. For instance, you can use a trust to pay any estate taxes that could come duc on your heirs' inheritance. You set up the trust, which then buys a policy that covers the expected estate-tax bill. Upon your death, the proceeds cover the taxes and your beneficiaries receive the total value of your estate.
This strategy works particularly well if inherited assets are tied up in a family business or real estate. Your heirs can pay estate taxes without having to sell off property or a business interest. "You don't want a fire sale on assets," says Kathleen Hartin, director of planning in the Houston office of Lincoln Financial Network, a financial-services firm.
A trust can also be useful in splitting assets in blended families. Say you're on your second marriage. You plan to pass most assets to your spouse, but you want to provide an inheritance for the two children from your first marriage. You could buy a $500,000 life-insurance policy and put it into a trust that directs $250,000 to each child. The policy will not increase your taxable estate, leaving more for your kids and your spouse.
No Going Back
But be aware that once you lock your insurance in a trust, you can't make any changes, including changing beneficiaries. And you won't be able to touch the cash value of the policy. "You're giving up access to the money," says Robert Romanoff, head of the Asset Planning & Preservation Service Group at Levenfeld Pearlstein, in Chicago. However, you can stop paying the premiums, effectively terminating the policy.
Also, creating a trust is expensive, costing from several thousand dollars to $15,000. In addition, you'll likely pay annual administration costs to cover such tasks as filing annual tax returns.
Once you set up a trust, you'll need to pick a trustee. You cannot serve as trustee because you cannot exercise any control over the assets in the trust. If your trust's distribution terms are complex and the policy is large, it's better to hire a corporate trustee, who can handle the intricacies. Ask for a quote on fees. You could name a friend or relative to act as a trustee, if the trust is straightforward and worth less than $250,000.
If you're thinking of creating a trust, don't dawdle. When you use an existing policy, the trust needs to be in effect for three years before you die, or else the proceeds will go back into your estate. You can avoid this rule if you create the trust first and have the trust purchase a new policy.