Proceeds from life insurance benefits have the advantage of being exempt from income taxes, but if you’re leaving behind a sizable estate, they can be calculated toward the estate tax.
The estate tax, or the death tax, as it is called by detractors, is a tax on sizable estates left by those who have died. Currently, the estate tax is levied only against estates valued at more than $2 million. This amount will increase to $3.5 million in 2010. The tax will be repealed in 2011, but will revive in 2012 at a $1 million rate, unless Congress takes action before then.While life insurance benefits are exempt from income taxes, they may be counted toward this estate tax if you’re leaving behind sizable assets. It is possible to avoid having your survivors pay estate taxes on your life insurance benefits if you create a life insurance trust.
A life insurance trust is an irrevocable, non-amendable trust which acts as both the owner and the beneficiary of a life insurance policy. After the insured dies, the trustee of the life insurance trust is responsible for investing the assets of the policy and making sure the insured’s survivors get paid.
Once you create a life insurance trust, you’re no longer the owner of the policy, the trust is. This means that you can’t take the policy out of the trust, you can’t take a policy loan and you can’t change the beneficiaries of the policy. You can, however, at the outset of the policy trust name beneficiaries and stipulate how you want the proceeds of the policy to be paid out.
One of the main benefits of a life insurance trust is that it gives your heirs a large pool of immediately accessible cash with which they can pay estate taxes on any business you may leave them without having to sell assets. For example, if you left a business worth $4 million to your heirs, this business would be subject to the estate tax, but your heirs might not have the cash to pay these taxes, since the $4 million you left to them is tied up in the assets of the business. Rather than have them sell business assets or close the business to pay taxes, if you have a life insurance trust set up, they can access the money in the trust to pay the estate taxes and preserve integrity of your business.
There are many other benefits to a life insurance trust. For example, any cash value and proceeds of a policy held by a life insurance trust are exempt from lawsuits and claims. This can be helpful if you feel that your estate might be tied up in business lawsuits after your death. Also, you can build up value in the policy fairly easily because money invested in the policy can accumulate tax-exempt value. This means that any money paid above and beyond policy premiums into the policy can be invested and earn money tax-free.
To fund the trust and avoid any taxes involved with doing so, you need to set up a Crumney trust. A Crumney trust allows you to make gifts up to $12,000 per year to your children so long as you give them the option of withdrawing the money from the Crumney trust within 30 days of it being paid. Once the 30 days have passed, the money in the Crumney trust can pay up premiums in your life insurance trust.
If you have an existing life insurance policy, it can be transferred to a life insurance trust. The downside to this is that if you die within three years of the transfer, the policy will be considered a part of your estate and will subsequently be subject to estate tax. This is why it is probably best to start a life insurance trust with a new policy, rather than trying to drag an existing policy over into the trust.
Perhaps the most important step in creating a life insurance trust is naming a trustee. You may not name a beneficiary of the trust as the trustee, because this will make the trust part of your estate in the eyes of the IRS. The best folks to name as trustees are either family members not covered by the trust or a financial professional. It’s good to name someone that you can trust to ensure that the proceeds of the trust are distributed according to your wishes.
The tax rate on estate taxes is high. For example, if you left behind an estate of $1 million in assets and a $1 million life insurance policy, your survivors would pay more than $300,000 in estate taxes. To avoid burdening your survivors with these large taxes, consider creating a life insurance trust.
You worked hard for your money. Leave it to your heirs, not your government.