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Your Money: Avoiding Estate Taxes


Mervin Low, MD, explains how a little-known type of trust can keep more of your money where it belongs - with your heirs - after you’re gone.

Life insurance is a simple and effective wealth-planning tool that is an essential component of any estate plan. For those with significant assets, life insurance is often purchased to cover estate taxes, which can sometimes consume half or more of an estate’s value.

But then there are the taxes owed on the death benefit itself. What, you thought life insurance benefits were tax-free? Well, yes - sort of.

The benefit is income tax-free to the beneficiary, but it is considered part of the deceased person’s estate and, therefore, subject to the estate tax. Note that if the beneficiary is a spouse, then the benefit is both income and estate tax-free, but upon the death of the spouse, the benefit would then become taxable to the heirs. This means that the death benefit so diligently paid over the lifetime of the insured be can cut in half. Hence, the irony of life insurance purchased to pay estate tax bills: Instead of offsetting the tax bill, the death benefit becomes part of the tax bill.

The solution to this is an irrevocable life insurance trust (ILIT). With the use of an ILIT - which is a trust created principally for the ownership of life insurance policies - the full value of the death benefit can be preserved and used to pay the estate-tax bill.

The trust is irrevocable and as such cannot be amended, rescinded, or modified after its creation. The trust becomes the owner and beneficiary of the insured’s policy; the insured must forfeit control of the policy. This sounds scary, but with a properly structured ILIT, the benefits paid to the trust will not be folded into the estate and thus will be excludable from estate taxation.

Typically, the beneficiaries of the trust are the children, but the language can be structured to allow for benefits to be provided to the surviving spouse. In essence, the trust can provide a living benefit for the spouse and an ultimate benefit for heirs. The provision regarding heirs can be additionally safeguarded with spendthrift and anti-alienation rules.

Generally, you’ll need to gift money to the ILIT for the policy premiums. The trust will need its own bank account and will have to pay the premiums to establish ownership. Alternatively, an existing policy and its ownership can be transferred to the trust. The transfer would be considered a taxable gift with a value approximating the cash-surrender value of the policy. Still, the tax cost of transferring the policy is usually less than the estate taxes that would otherwise be due. If the insured dies within three years of the transfer of the policy to the trust, the “three-year look-back” rule will be invoked, and the policy will be brought back into the taxable estate. This would negate any tax advantages gained by the transfer of the policy.

An ILIT has asset protection advantages, too. Some states will completely protect a life insurance policy’s assets; others offer no protection. Since the policy and premium funds are owned by the ILIT, they are usually protected from creditor claims.

Is there any downside to establishing an irrevocable life insurance trust? It depends. The expense and expertise required to set up an ILIT may be a deterrent for some. Others may dislike the irrevocable nature of the arrangement, the ultimate loss of control of the trust’s provisions, and the potentially inaccessible cash value of the policy.

Still, an irrevocable life insurance trust is an underused tool for the ownership of life insurance policies and the minimization of estate taxes. Because one is no longer considered the owner of the policy, it is therefore not included in one’s estate and is consequently not subjected to estate taxes. Such a trust should be considered for those with large estates.

Mervin Low, MD, is a plastic surgeon practicing in Southern California. He is also a Certified Wealth Preservation Planner and Certified Asset Protection Planner. He can be reached by e-mail at drmlow@gmail.com or via editor@physicianspractice.com.

This article originally appeared in the October 2007 issue of Physicians Practice.

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