| DENVER
- One of the enduring myths about life insurance is
that its death benefits are tax-free.
True, the proceeds are free of income tax for the beneficiaries.
But those same benefits may be
subject to tax in the estate of the insured. That's
the irony of buying life insurance to pay for estate
taxes, often a strategy used by
those whose gross estate exceeds the tax-free $675
,000 limit. The policy proceeds intended to
pay the estate tax bill become part of the bill themselves.
Let's say you have an estate facing
a federal estate tax of $200,000. If you buy a $200,000
life insurance policy to pay the estate
tax bill, the proceeds will be added to the total value
of your estate, and you'll end up owing
at least another $75,000. One
way out of this dilemma is to set up an irrevocable
life insurance trust, which takes over
ownership of the insurance policy, says Michael Snowdon,
CFP, CMFC, and the CFP Program Manager at
the College for Financial Planning®, a division
of the National Endowment for Financial
Education ®(NEFE ®). "One of the big advantages
of a life insurance trust is that it
removes the life insurance from the estate of the insured." The
trust also may serve other ends. For example, at the
death of the insured, the policy proceeds
may remain in trust to provide regular income for the
surviving spouse (while keeping the assets out
of the spouse's estate). Or the trust may be used to
distribute proceeds to children from a previous
marriage. "A
life insurance trust can be set up with a great deal
of flexibility". "For example, the trust can
distribute a limited amount of the insurance proceeds
over a period of time to a financially
irresponsible child. Yet should that child suddenly
have need of extra money, the trust can provide
additional funds at the discretion of the trustee". Despite
the advantages of an irrevocable life insurance trust,
Winter advises anyone thinking about
setting one up to keep these points in mind: - It's
irrevocable.
Technically, life insurance trusts are called irrevocable
life
insurance trusts, or ILITs. To keep the policy out
of your estate, you must give up complete control
over it. That means you can't change the beneficiary,
cancel the policy, borrow against it, or
otherwise alter the terms should circumstances change.
You can't even legally compel the trustee
(the person managing the trust) to use the proceeds
to pay estate taxes. Consequently, the trustee
should be someone who is competent and who you are
certain will carry out your wishes (usually
outlined in written instructions). A common choice
is a close friend or a financial institution, but
someone who is not a beneficiary.
- The insurance can come back to your estate.
If you transfer a policy into a life
insurance trust, but die within three years of that
transfer, the policy ownership reverts to your
estate and the estate pays tax on the proceeds. One
way around this risk is to have the trust buy a
policy on the insured's life.
- The beneficiaries can spend some of the trust funds.
Whether you transfer a policy into a
life insurance trust or have the trust buy a policy,
you'll need to gift to the trust sufficient
funds to pay the premiums. But to meet the gift-tax
exclusion rules, you'll have to include what's
known as a Crummey
provision (named after a court case). This provision
allows beneficiaries
the opportunity to withdraw their share of the gift,
typically within a certain time, such as 30
days. Most financial advisors recommend using the "five
by five" rule, meaning that a beneficiary
may take the greater of $5,000 or 5 percent of the
trust assets as the limiting factor for the
amount to be withdrawn. Obviously, if they do withdraw
funds they've defeated the purpose of the
trust.
- Trusts cost money.
Beyond the cost of paying for hefty insurance premiums,
legal fees for
a life insurance trust can easily run $1,500 or more.
In
view of these drawbacks and risks, some might argue
that it is easier to simply have the
beneficiaries directly own policies on the life of
the insured and dispense with the hassle of an
ILIT. In some cases, this may be appropriate. However,
the beneficiaries may not be mature or
responsible enough to use the money to pay estate taxes
or as otherwise intended by the insured.
Also, divorce, bankruptcy, or a lawsuit against a beneficiary
may allow access to the policy's cash
value or the proceeds by the ex-spouse or creditors.
An ILIT would prevent this. Separate policies
also are more complicated if several beneficiaries are involved.Provided
by the College for Financial Planning  |
©May, 2000, the College for Financial Planning,
all rights reserved.
|
|