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Monday, June 17, 2013

Uses of Life Insurance in Estate Planning


Life insurance has many uses available during the course of planning for one’s ultimate demise.

In the earlier stages of life, the principle purpose of insurance is often protection against untimely loss of the income of the family provider. A policy that builds or maintains cash value in addition to the death benefit can be used as a tax-free vehicle for investment within certain limits.

For individuals with estates large enough to incur estate tax, an insurance policy that is properly structured can provide a hedge against the tax burden. One of the most popular methods of owning an insurance policy for estate tax purposes is through use of an Irrevocable Life Insurance Trust, commonly called an ILIT.

In order for an ILIT to be most effective for the intended purpose, the insured should neither be a trustee nor a beneficiary of the trust. Ordinarily, if a person owns a life insurance policy on his or her own life, the death benefits are included in the insured’s taxable estate. By eliminating the rights to control the policy and reap any of its benefits, the assets of the ILIT (including death benefits) will not be subject to estate tax. Since life insurance proceeds are not subject to income tax either, a properly maintained ILIT serves almost like a tax haven for the trust beneficiaries.

The complexity and potential challenges of estate planning reinforce the advantages of using an ILIT to pay estate taxes. Some of the advantages are as follows:

  1. The accumulation of cash values is not subject to current income taxation; hence, the trustee can access cash values tax-free by surrendering the policy (up to basis) or borrowing against the policy.
  2. Gifts of cash to pay life insurance premiums of up to $14,000 per donee ($28,000 if married) may qualify for the annual gift tax exclusion, thereby avoiding current gift taxes. These gifts also decrease the insured’s estate, lowering future estate tax burden.
  3. For two reasons, the internal rate of return for many policies will be favorable compared to alternative investments. First, in the case of a premature death, the insurance policy produces an unparalleled return on investment. Second, since the death benefit is income tax-free, the projected rate of return is enhanced.
  4. Finally, life insurance provides a business owner’s estate with liquidity when it is most needed. The death proceeds received by the ILIT can be used to purchase assets from the business owner’s estate or to loan funds to the estate to pay the estate tax.

While ILITs have been in use for several decades, life insurance has been around for centuries. And as laws have changed and as people’s lifestyles have changed over the years, use of life insurance has changed as well. Recent trends include creating an ILIT that includes an option to add the surviving spouse as a beneficiary.

Spousal Lifetime Access Trusts, also known as SLATs, do not initially include the spouse as beneficiary in order to avoid increasing the surviving spouse’s taxable estate; however, provision is made to allow the spouse to be added as a beneficiary if he or she suffers from hardship or a lower standard of living.

There is also a trend toward use of a life insurance policy as a combined Retirement And Legacy Account (RALA). RALAs utilize loan strategies to afford the insured with tax-free retirement while providing the beneficiaries with a lump sum on death. These trending uses are often done without using the ILIT method, but when utilized within the confines of an ILIT the benefits are often magnified.

An ILIT can also play a role in other estate planning strategies. For example, if the business owner’s estate qualifies for deferral of estate tax and the interest rates are favorable, the ILIT assets could be invested in marketable securities. Then when the tax installments are due in years 5 through 14, the highly liquid ILIT could be tapped as a loan source to make up any shortfalls in liquidity of the estate.

A similar strategy could be used to enable a corporation to engage in an IRC §303 stock redemption. The ILIT could loan a portion of the death proceeds to the corporation to help it consummate a redemption. This is preferable to having the corporation be the owner and beneficiary of the policy, thereby risking an increase in the value of the business for estate tax purposes.

In summary, an ILIT is a popular and effective tool to help meet the estate liquidity needs of a business owner. Due to its tax-advantaged status, an ILIT—standing alone or in conjunction with other planning opportunities—can be an opportune source for payment of estate taxes, thereby assuring that the family assets actually stay with the family.

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