Feel like you paid the government to much in taxes recently? Well guess what, the IRS may be inheriting half your life insurance as well. That’s right, your life insurance may be subject to estate taxes at a rate of roughly 50% if you are an individual or married couple with assets (including life insurance) greater than $1,000,000*. That means your $500,000 life insurance policy may be only worth $250,000. The good news is that this can be prevented by using a Life Insurance Trust to shield the proceeds from taxation.
The way a Life Insurance Trust works is simple. First, a Trust is drafted, in which you name someone, other than yourself, as a trustee. You also name the beneficiaries of the trust. Second, the trustee applies for life insurance on your life. The Trust, not you, is both the owner and beneficiary of the insurance. Third, you make gifts to the trust each year, which are used by the trustee to pay the life insurance premiums. Because you do not own the policy, when you die the government does not consider the insurance proceeds as an asset of your estate. The proceeds pass estate tax free to the Trust, and are then distributed to the beneficiaries according to your instructions.
Unlike a life insurance policy by itself, a Life Insurance Trust allows you to state when and under what conditions the proceeds will be paid to beneficiaries. This is an added benefit of a Life Insurance Trust which can insure that immature beneficiaries will not squander their inheritance.
*(Note: This $1,000,000 exemption from estate taxes assumes a date of death after January 1, 2011. For deaths occuring before that date the exemption amount is higher. For a more detailed explanation of the rules on estate tax exemptions see our article “Making Sense Out of Estate Tax Exemption Nonsense.”)