Protecting Your Estate with Life Insurance

22 Dec, 2008

Protecting Your Estate with Life Insurance

Posted by: earlhines In: Estate Planning| Insurance

Earl Hines

Consider an Irrevocable Life Insurance Trust

Recently, clients of mine were faced with important decisions regarding the future transfer of their estate. Because a large portion of their wealth is concentrated in the family’s business, the couple was concerned that their children might not have the available cash to pay estate taxes after their deaths. Their goal was to ensure the children could keep the business rather than be forced to sell it simply to pay the IRS.

The Death Tax

Every American is entitled to an estate tax exemption on the first part of his or her estate. With proper planning, a married couple can double that exclusion shelter. The exclusion is $2 million per individual in 2008 and increases to $3.5 million in 2009. The estate tax is repealed in 2010 but then returns in 2011 with an exclusion of $1 million.

At your death, your beneficiaries can inherit your estate, income tax free, but the proceeds are not estate tax free. Estate taxes are a maximum of 48 percent at the federal level, and when you add state taxes, the total liability can easily consume greater than half of your assets. To say the least, this takes quite a bite out of your estate. Unless you protect it, your legacy could be lost needlessly to the government.

Protecting Your Legacy

An Irrevocable Life Insurance Trust (or ILIT) allows you to protect your loved ones without adding to your estate taxes. This trust can acquire and pay for insurance on your and your spouse’s life, and upon your death, the proceeds from this insurance are outside of your estate, and not subject to taxation.

By working with an attorney, you can set up an ILIT, name a Trustee that is not yourself, and name your heirs as the beneficiaries. Your Trustee is required to follow the precise instructions you provide in your trust documents. He or she will purchase life insurance on your lives with funds that you provide as “gifts” to the trust.

Gifts To Your ILIT

Annually, a taxpayer may give up to $12,000 to another person gift tax-free. This amount increases to 13,000 in 2009. Married couples, therefore, can give a combined total of $26,000 gift tax-free to any one person. Other than this per-person rule, there’s no limit on the total amount you can give away. For example, if you have three children and five grandchildren, you and your spouse could give each one $26,000, for a total of $208,000 annually! This can buy a lot of life insurance coverage.

CAUTION: It’s very important that you ensure your children, particularly if they are young adults, understand and support this part of your estate plan. When you provide your Trustee with the funds to pay your annual premium, your Trustee must notify your beneficiaries in writing that a gift has been made in their names. Your beneficiaries will have the option of withdrawing these funds from your ILIT during a specified period, usually up to one year. When they don’t exercise their option, your Trustee will use the money to pay your insurance premium. This written notification of your gift to your beneficiaries is known as a Crummey Letter, named for the taxpayer who won a court case against the IRS resulting in approval of this process. Obviously, if your children chose to withdraw the funds they would sabotage your entire strategy, so it’s important that they understand the importance of the ILIT and why they should not do this.

Paying Estate Taxes

In the case of my clients, they set up an ILIT to ensure their children would have enough cash after their deaths to pay the estate tax, without selling the family business. Since the life insurance contract is owned by the ILIT, the proceeds from the policy contract fall outside of the clients’ estate. Since the proceeds of the insurance are payable to the ILIT, with the children as the beneficiaries, this cash can be used to settle the estate taxes.

Even if you’ve engaged in estate planning in the past, it is important to revisit your documents periodically as the law and your specific circumstances may have changed. An ILIT may be a useful tool in your estate plan, but it is only one of the tools available to you. You should work with your financial advisor who can lead a team including your estate attorney and CPA to evaluate your specific needs and make recommendations.

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Tags: Estate Planning, Insurance

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