How To Avoid Estate Taxes On Life Insurance
by Bernard Fruchtman, Esq.
Life insurance proceeds are free of income taxes. In addition, the proceeds go directly to beneficiaries, bypassing probate (the often time consuming process of certifying the will).
However, if you own the life insurance policy at your death, or if you have any ownership rights (explained below) in a policy the proceeds will be included in your estate and will be subject to estate tax.
Advantages of a Life Insurance Trust:
If you set up an irrevocable life insurance trust you get the following benefits:
1. Removal ofthe proceeds from your taxable estate
2. Reduction ofprobate costs (probate fees are often based on a percentage of the value of your estate)
3. Insulation of the insurance policy from your creditors
Ownership rights in a policy include the following:
- a right to any part of the proceeds
- power to change the beneficiary
- power to assign the policy or revoke an assignment
- power to borrow against the cash surrender value
How An Irrevocable Life Insurance Trust Works:
To keep the proceeds of your life insurance policy out of your estate you give the policy and all control (rights of ownership) over it to a trust that is totally irrevocable.
The decision to make the transfer is permanent and can’t be changed or reversed once it is made.
The premiums on the policy are paid by annual gifts that you make to the trust.
On your death the proceeds of the policy are paid to the trust and invested.
Provisions can be made to receive payments from the trust if your spouse ever needs income. At some point in the future, your children or other beneficiaries you’ve named receive the trust’s assets.
Another option for disbursing the funds might be to provide that the
trust pays any taxes due on your estate. This provision will allow your
entire estate to pass intact to your heirs. There are many other options
that can be used to disperse the policy proceeds and the one that is most
appropriate for you will depend on your particular circumstances.
Tax Trap #1
When you transfer money each year into the trust to pay premium you are
making a gift.
To qualify as a tax free gift (subject to the $10,000 per person
limit, $20,000 for joint gifts) your gift must considered a present
interest – a gift that can be enjoyed at the present. A future gift isn’t
If you give the beneficiaries of the trust an opportunity to
withdraw their shares of the annual contributions you make to the trust,
the gifts will be considered present interests and covered by the $10,000
gift tax exclusion.
The opportunity to withdraw funds is made available for a limited amount of time, generally 30 days. Of course, you don’t expect your beneficiaries to take advantage of it. This power to withdraw is known as a “Crummey” power, named after the court case in which the effect of the power was first tested.
Tax Trap #2
Transfers via gift of ownership in a policy made within three
years of death are considered part of your estate even though you have
given up all rights of ownership.
Cash in your current policy and have your trustee purchase a new
policy. Simply giving your trustee money to pay premiums on a new policy isn’t considered a right of ownership and thus, isn’t affected by rule of ownership within three years of death.
Disadvantages of Trust:
1. Once you set up an irrevocable trust you can’t undo it and
2. You lose complete control over the policy
3. You can’t borrow against it
4. You can’t change the beneficiaries of the trust
5. You have to pay annual trustee’s fees
6. The trust may have to file income tax returns.
If you decide you’ve made a mistake after you’ve set up an irrevocable
life insurance trust you can stop making gifts to the trust to pay the
The trustee would then be forced to let the policy lapse and
distribute any cash value to the beneficiaries.
Bernard Fruchtman, Publisher/Editor
TaxTalk – Plain & Simple
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