Your Three Priorities
Formulating a plan to provide immediate liquidity for your family upon death is your first priority. It’s hard for people to face their own mortality but we all need to prepare ourselves financially for the benefit of our loved ones. People purchase life insurance policies to provide their families with instant liquidity at the time of their death. Immediate survivors experience conflicting emotions. Major decisions are required with urgent time constraints. Your family will need cash to pay for planned and unplanned expenses.
Calculating what amount of liquidity will be needed to administer your estate is your second priority. Soon after your death, the process of administration will begin. This is the next challenge for your loved ones, your executor, your trustees. They’re responsible for paying bills, collecting debts, preparing distributions, making gifts and the final tax return. Will there be enough cash to pay off margin accounts, property loans and other investment notes? It’s a big job.
Estate Taxes are your third priority. If you leave an estate exceeding the $5.43m lifetime exemption, your heirs face estate tax obligations of up to 50% of the value of your estate above the lifetime limit. And this tax debt must be paid in cash within 18 months, or it begins to accrue interest. Your may need to obtain loans against equity or quickly sell assets. Maybe you provided standby liquidity with insurance to pay taxes… or not.
Life Insurance Is For the Immediate Cash Needs, the Administrative Needs and the Tax Liabilites of Your Estate
And, yes, life insurance is a real expense. But it’s like an option. When you exercise that option at death, liquidity relief is created to address financial needs.
When Should Life Insurance be Owned by a Life Insurance Trust?
You really do not need a life insurance trust if your estate has a total value less than $5.43m including your policy proceeds. However, when your estate exceeds $5.43m, there are significant tax benefits to holding that insurance outside of your personal estate.
Let’s look at the numbers. If you have a $10m estate and your $2m life insurance policy is in your name, your taxable estate is $12m. Subtract $5.43m and your estate taxes are now calculated on $6.57m – thus increasing your estate taxes. However, if the $2m life insurance policy is owned by an independent life insurance trust, your estate taxes are calculated on $4.57m. And the $2m proceeds are tax free for the beneficiaries. Depending on the face value of the policy the trust purchases, heirs may have enough to pay the taxes or more.
The Importance of Two Policies If Married
If you have an larger estate, for example over $30m, and are married, consider one policy for each spouse. Each spouse lends a distinct, yet tremendous value to the partnership. Generally, each spouse is safer with their own policy for the benefit of the survivor. This means two policies and two insurance trusts.
Life Insurance Trust is One Way
Once it is estimated that an estate will likely exceed lifetime tax free limits, an insurance trust is best. The trust is designed to hold and distribute proceeds from a single asset, the life insurance policy. Hence, “life insurance trust.”
Once setup, it’s permanent. The policy remains unchanged, beneficiaries remain unchanged, no borrowing against the policy. It’s a one way street and that is the cost of tax free benefits. In this context, it is “irrevocable.” You now understand the term, “irrevocable life insurance trust,” – ILIT.
Depending upon your needs and personal situation, you might have more than one insurance trust. What if you prefer to keep a beneficiary anonymous and separate from your other affairs? You can also dictate the terms of any trust payout, e.g., immediate disbursement for taxes, obligations paid, staggered income payments for a beneficiary, medical emergencies, funds for college education, gifts, etc. Or you can leave it all up to the discretion of your trustee.
An Important Note About Who Funds the Policy
The purpose of an insurance trust is to exclude the cash death benefit from your taxable estate. For this to be effective, you need an independent life insurance trust as the legal owner. If the insured is married in a community property state, it is imperative that he/she fund the trust with their sole and separate property. This is because improper funding of the policy can jeopardize what is each individual’s separate non-taxable estate. So the insured ‘funds the trust’ which in turn pays for the policy.
The insured can use an annual gift exclusion ($14k in 2015) distributed from the trust to fund premiums. If the premium for the policy is $20,000/year, then two $10k gifts made to the insurance trust beneficiaries can be used to pay for the premium. However, for this gifting to work, the $10K gift to the beneficiaries must be “unrestricted”. This means that the beneficiaries have the right to receive and spend these monies without restriction. Because it is in the best interest of the beneficiaries to keep the insurance policy in force, they are incentivized to agree to this arrangement. The beneficiaries simply refuse to accept the money and after a 30 day waiting period from the time of the gift, the trustee applies the funds to pay premiums.
The trust obtains an IRS identification number. It opens a bank account which is where premiums are funded and paid. Eventually death proceeds are received and distributed from this account.
This mechanism to fund premiums with a tax free gift is also known as a “Crummey Power.” (letter) It was first established in 1968 from a landmark IRS case. Sometimes it’s known as a Crummey Insurance Trust. In 1985 the Cristofani case arose when “contingent, successor beneficiaries” were named. The idea was to multiply annual tax free gifts. The IRS challenged this expansion.
Setup & Selection of Trustees
You will incur fees to set up an insurance trust. The people you need include a trustee , a life insurance representative, accountant, and possibly an attorney to review.
If you currently own a policy, you might transfer ownership to the trust contingent upon the insurance company’s approval. However, if you die within three (3) years of transfer, the proceeds might be included in your estate. The safest approach tax wise is to have your trustee apply for a new policy on behalf of the insured. The trustee pays for and become the owner of a new policy. Yet sometimes a new policy is difficult because of recent medical issues.
Should your trustee have significant or ongoing responsibilities, they should earn appropriate compensation. Trustee selection requires careful consideration with respect to experience, integrity and knowledge of financial matters. Your trustee must remain vigilant so that the policy remains in force, rules are followed, communication with the insurance company remain responsive, and premiums paid on time.
Tap into the Unique Power of Trusts
To tap into the unique power of trusts for ensuring a secure financial future you need an expert, and we are the experts across a broad range of infinitely valuable private trusts. TrustArte is here to personally assist you. We’re here to educate you. We’re here to give you the financial privacy you not only deserve, but need.
Our Open Philosophy Trust Arte will openly engage with other professional advisors such as tax specialists, attorneys and accountants to develop the most effective solutions for our clients. Should their services be of value to you, our trust professionals will work with your other advisors. This “open architecture” philosophy, which is reflected throughout our organization, allows us to build closer relationships with our clients and offer them the best solutions.