Irrevocable life insurance trust can help sidestep tax issues

This article was provided by Timothy M. Reese, senior vice president of investments with A.G. Edwards & Sons Inc.

After working hard for years to build wealth, it's important to that those assets be carefully preserved. While a will and a trust are two important components of an estate plan, they can still leave heirs with a considerable tax bill. One vehicle that can significantly ease the tax burden for heirs is an irrevocable life insurance trust. An irrevocable life insurance trust is a vehicle for holding an insurance policy so that it will not be included in the taxable estate.

An irrevocable life insurance trust is structured so the trustee of the trust itself owns the life insurance policy. The donor pays premiums into the policy by taking advantage of annual gift exclusions, which allow an individual to gift up to $11,000 without tax consequences (for married couples the amount is $22,000).

The maximum amount an individual could contribute to an irrevocable life insurance trust depends on the number of beneficiaries named in the trust. For example, if five children are named as beneficiaries of the trust, an individual could contribute up to $55,000 annually to the trust ($110,000 if married) to pay the premiums on the life insurance policy held by the trust.

Upon the death of the donor or the donor and spouse, the life insurance policy's proceeds are paid to the trust. The trustee then distributes that money to the beneficiaries as outlined by the terms of the trust.

By definition, an irrevocable life insurance trust is "irrevocable" to the donor, meaning the donor cannot change the trust or cash out the policy and personally receive the funds. Instead a trustee holds the life insurance policy, and he or she can liquidate the policy per the terms of the trust, and distribute proceeds to the beneficiaries of the trust.

Typically, an individual could hold a life insurance policy on himself or herself. However, upon the individual's death, proceeds from the policy would be included in that individual's estate and could therefore be subject to estate taxes, which can account for up to 50 percent of the value of an estate's assets. In an irrevocable life insurance trust, the life insurance policy is held by the trustee, therefore it is not included in the donor's estate and is not subject to the estate tax.

Should you choose to set up an irrevocable life insurance trust, it is key to select a trustee that you believe will carry out your wishes for your estate. A trustee's obligations include making investment decisions that parallel the goals of the trust, maintaining accurate financial records and complying with IRS regulations. Some people choose a close friend or relative while others find it beneficial to name a corporate trustee because of the numerous duties a trustee must perform.

Talk with your tax and legal advisers about the best way to help your family avoid a big tax bill along with their inheritance.