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Alexandria, VA Estate Planning Blog

Friday, October 29, 2010

The Estate Tax Implications of Life Insurance Trusts

(Letter given to Potential Clients. This Letter isn't intended to create an attorney-client relationship or to be construed as legal advice) 

Few people realize that, even though they may have a modest estate, their families may owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a substantial death benefit. Life Insurance proceeds are generally considered part of your taxable estate and are subject to federal estate tax.

The solution to this problem may be to create an irrevocable life insurance trust that will own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own "excesses", against their creditors, and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets.

E.G., George has a life insurance policy (L.I.) worth 1 million dollars. In 2011, George passes away with other assets equal to 1 million. The L.I. is included in George’s estate and the government seizes $550,000 (1 mill *55%). If a life insurance trust was used, the L.I. likely would not have been included in George’s estate.

Figures

Other Estate Assets $1million

Life Insurance Estate Asset $1 million

Total Estate Assets $2 million

Estate Tax Credit (Non-Taxed Portion) $1million

Assumed Tax Rate 55%

Tax Liability = $550,000

Potential Result if Life Insurance Trust Implemented: TAX SAVINGS $550,000 Page 2 of 3

Note: (Even though the estate tax has been repealed, the repeal is effective only for 2010. The estate tax is scheduled to return in 2011, and may even return before then if Congress reinstates the tax retroactively.)

How Irrevocable Life Insurance Trusts Work

You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won't have to pay gift tax on the contributions.

The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee's discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.

If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you. If you have questions, feel welcome to contact me at my office.


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