Irrevocable trust can protect insurance from estate taxes

by Brian E. Hamburg

for the Business Journal

Like most everyone in the working world, you probably have people who depend on you financially. You provide a home and the necessities of daily living for those you love. You are planning for retirement and good education for your children. You probably have life insurance to provide for loved ones in your absence.

The concept of life insurance is pretty simple: you pay premiums to the life insurance company, and the insurance company pays a benefit to your family. However, some families have been shocked to find out they do not receive all of the insurance proceeds.

How can this be? The answer is federal estate tax. In some cases, more than half of the life insurance proceeds intended to benefit a family have gone to the government instead.

When your family is paid life insurance proceeds, the money is included in your gross estate for the purpose of determining estate tax liability. Because policies are commonly purchased with a payout benefit of $250,000 to $1 million or more, the value of an estate can add up quickly.

The insurance proceeds will be added to the other assets in your estate, including your home and furnishings, cars, savings, investments, retirement accounts and almost anything else you own.

This can quickly exceed $650,000, which is currently the amount at which you start paying estate tax at very high rates: currently between 37 percent and 60 percent.

Fortunately, there is usually a way to prevent this result. One solution is an irrevocable life insurance trust. With an irrevocable life insurance trust, the trust owns the life insurance.

After the trust is set up, you can assign your existing insurance policy to the trust or you can have the trust apply for the policy directly. Either way, the trust owns the policy and all of the rights which come with it. For that reason, none of the proceeds are included in your estate.

Even though the trust owns the policy, you can say how the trust is drafted. Therefore, when the trust collects the policy proceeds, payment will be made out of the trust as you originally requested.

For example, the trust may provide payments to the surviving spouse for his or her needs.

It may also provide that your children shall have their education and living expenses paid until an age which you specify. Thereafter, the children can receive the remainder of the proceeds in a lump sum. The terms of the trust are flexible, and you can establish them to meet your needs.

As the name "irrevocable life insurance trust" suggests, you cannot revoke this trust. If circumstances change so that you strongly wish to alter the trust beneficiaries or otherwise change the terms of the trust, you do have some possibilities.

You could allow the life insurance to lapse by not putting more money into the trust. That assumes you can obtain replacement insurance.

If that is not possible because of a change in health, it is possible that the old trust can sell the life insurance policy to a new trust created by you, so long as the purchase price of the insurance policy is adequate. The new trust has the revised terms that you want.

What if you are passing everything to your spouse? Will that avoid estate tax? Only temporarily. If the marital deduction is properly used, estate tax will be delayed. However, your spouse will likely pass all of the marital assets and the unused part of the life insurance proceeds to the children, who have no similar deduction. Thus, the payment of taxes would only be delayed instead of avoided altogether.

With an irrevocable life insurance trust, the proceeds can stay in the trust and pass to your children with no estate tax.

What about those who already have a revocable inter vivos trust (living trust)? Do they still need a separate trust for life insurance? Probably so. The inter vivos trust is very useful, but usually will not avoid the payment of estate tax on life insurance proceeds.

As with all estate planning, there are many traps for the unwary. The irrevocable life insurance trust must be handled very carefully, so you should talk to your attorney before proceeding.

Ideally, your attorney can work directly with your insurance professional for the best results.

While using the irrevocable insurance trust can be tricky, it has tremendous advantages. Putting your life insurance in this special kind of trust can save literally hundreds of thousands of dollars.

(Brian E. Hamburg is an attorney with the firm of Harrison, Tucker & Hyde LLP, attorneys at law, in Springfield.)

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