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Estate Tax Planning

What is estate tax planning?

¬†Estate planning involves preserving your estate for the transfer to your heirs and the proper distribution of your estate’s assets. Proper planning is important to avoid dying intestate which means passing away without a will or trust that provides instructions as to how your estate is to be transferred and to whom.

What is a trust?
A trust is an agreement made between two parties for the benefit of a third party.

What is an Irrevocable Trust?
An irrevocable trust is a trust in which the grantor cannot change the terms of the trust or terminate it. In addition, the grantor does not have access to the funds in the trust.

Estate Planning and Life Insurance
You work a lifetime to accumulate an estate; however, at your death the assets you pass onto your heirs may be subject to federal estate taxes and state inheritance taxes. If your estate is subject to estate taxes, taxes are due usually within 9 months of your death. Life insurance can play an important role in estate planning by providing the income necessary to pay estate taxes and expenses and provide liquidity so those expenses can be paid. Some expenses that must be paid upon an individual’s death may include:

  • federal estate taxes
  • state inheritance taxes
  • probate fees
  • legal and administrative fees
  • debts
  • funeral expenses

There are three options to pay estate taxes and expenses: use cash (it may be unlikely there will be much cash available), borrow the money (the money will have to be repaid with interest), pay the IRS in installments under IRC Section 6166 (only available for closely held family businesses or farms and there will be an IRS lien placed on the business), or pay now by purchasing a life insurance policy with the possibility of paying pennies on the dollar. Proper planning now may enable you to pass more of your estate to your heirs. Proper planning involves identifying estate transfer costs (federal estate taxes, state inheritance taxes, probate, etc.), using available tax breaks to reduce costs and determining the least expensive method of paying for remaining taxes and costs. The funded irrevocable life insurance trust can be one of the most cost-effective ways to pay for estate taxes.

The Basics of an Irrevocable Life Insurance Trust
The irrevocable life insurance trust (ILIT) is used to shield assets, in this case life insurance, by removing the ownership and control of the policy from the estate. Life insurance is a common tool used to fund estate taxes and expenses upon the death of an individual and the transfer of a large estate. For married couples, a joint life insurance policy is commonly used because it insures both lives and pays a death benefit upon the death of the second spouse (when estate taxes will be due). In addition, the annual premium for this type of policy is often considerably less than a policy purchased on one person’s life. If the life insurance policy is not removed from the estate then the proceeds of the policy will also be subject to estate taxes.

Ideally the trust should be created before the life insurance policy is applied for. After the trust is created the trustee applies for a life insurance policy and makes the trust the owner and beneficiary. If a life insurance policy is already in existence before the trust is created, then the policy should be gifted into the trust by the policyowner. This is done by changing the owner and beneficiary of the policy to the trust. If a life insurance policy is transferred into a trust that was created after the policy was issued then the transfer is subject to the three-year rule. The three-year rule states that if a death benefit is paid within three years of the transfer then the proceeds will be included in the grantors estate and thereby subject to estate taxes. The premiums for the life insurance policy in an irrevocable trust are paid for by the trustee with gifts made to the trust by the grantor and spouse. The trustee administers the trust and any distributions. Upon the death of the second spouse, a joint life insurance policy (otherwise known as a second-to-die policy) will pay a death benefit to the trust. The trustee will then distribute the life insurance proceeds according to the terms of the trust document. This type of arrangement is valuable because it can provide the liquidity and income to pay the estate taxes and expenses immediately so that the estate can remain intact when passed to the heirs.