An initial estate plan often consists of a will, power of attorney, health care proxy and perhaps a revocable trust. However, as a person’s financial situation becomes more complicated, or their accumulated assets increase, one of the first steps in developing a more advanced plan is to establish a trust to own a life insurance policy. Why? Because life insurance is a valuable tool for protecting assets and reducing taxes. However, it can also be a trap for the unwary if not planned for properly.
Every individual has a certain amount of assets which they can pass to heirs free of estate and gift tax. At the federal level, the current exemption amount is $15 million. In New York, the amount is considerably lower, at $7.35 million for estate taxes only. (There is no gift tax in New York.) The tax burden when you exceed these thresholds can be significant.
While $7.35 million may seem like a very high amount, what many people do not know is that if you own a life insurance policy on your own life, the full death benefit of that policy is included in your taxable estate. This can cause problems for some estates by putting them over the estate tax exemption amount.
Life insurance is a key component of financial planning, allowing individuals to leave funds for their loved ones to replace the lost income of the deceased spouse, meet future expenses or provide additional financial security. Therefore, most people want to preserve the use of life insurance without worrying about taxes. A trust can be used to minimize taxes, but the impact can vary based on the type of life insurance.
The most basic type of insurance is term insurance. The policy pays a death benefit if you die during the term of the policy (often 20 or 30 years). If you survive beyond when the policy term ends, there is no death benefit. For this reason, term insurance is relatively affordable, with millions of dollars of death benefit available for annual premiums in the low 4 figures. A high death benefit can use a significant part of your taxable estate exemption if you own the policy personally. However, if you purchase a policy with a trust, or transfer an existing policy into a trust, the death benefit is removed from your estate.
An important caveat is that transferring an existing policy into a trust may use a portion of your exemption depending on the type of policy. Some common types of life insurance, such as universal, or whole life policies (which do not expire) use a portion of the insurance premium to build up what is known as cash value. This is an amount you can borrow against or withdraw during your lifetime. The amount of this cash value dictates whether any portion of the estate credit is used when transferring an existing policy into a trust.
With term insurance, there are no lifetime benefits or cash value, so putting the policy into a trust does not use any portion of your estate tax exemption.
When transferring an existing universal or whole life policy, the policy has a transfer value, which generally is the accumulated cash value. That transfer value equals the amount of the federal estate tax exemption that is used when transferring the policy to an insurance trust. (Note that generally a gift tax return must be filed for the transfer.)
Notwithstanding this limitation, in most cases, there is little downside to transferring life insurance to a trust compared to the benefits. However, you should note that with universal and whole life policies, the trust must be properly drafted in order to preserve the ability to benefit from the policy’s cash value and minimize use of the exemption to benefit your surviving spouse or heirs.
Another issue is that paying premiums is more complicated when the trust owns the policy because a trust bank account must be established, from which premiums must be paid. There is a multistep process that must be used to fund those premiums to avoid creating other, unintended tax consequences (this will be discussed in greater detail in a future post).
The trust must also be irrevocable, which means that you don’t have the flexibility to change the beneficiaries of the policy. However, you can appoint a Trust Protector in the trust document who has the power to make changes to the trust, which gives you some control.
If you don’t have a comprehensive estate plan or haven’t reviewed yours with an attorney in the last few years, contact us for a consultation. Proper estate planning can save your family time, money and stress.