Life insurance policies can help provide for loved ones, but when the policies are set up as life insurance trusts they can also save on taxes.
Death benefits paid to beneficiaries are generally not taxed as income, and can provide tax-free transfer of wealth from one generation to another. The payment does count toward the estate of the deceased and can be taxed when the value of the estate exceeds allowed exemptions.
Under current rules, which provide sizable exemptions, only the wealthiest Americans are likely to pay estate taxes, but this situation is not expected to last forever. The tax rules surrounding estate planning are set to expire at the end of 2012, and many expect Congress to increase estate taxes to help reduce the nation’s record $14 trillion deficit.
For the 2011 tax year, the IRS exempts the first $5 million of an individual estate, or $10 million for that of a married couple. Annual gifts of $13,000 to each recipient, as well as lifetime gifts of $5 million for an individual, or $10 million for a married couple, are also exempt.
Investors with large estates are using life insurance policies are part of an overall strategy to save on taxes. An April survey by Spectrem Group, a market research firm specializing in affluent investors, shows that more than 25 percent of the wealthy uses life insurance policies to save on taxes.
Affluent investors have a net worth of $500,000 or more, excluding their primary residence. Their tax-saving strategy also includes bonds, annuities, IRAs and real estate holdings.
Investors can use life insurance policies to shelter their assets from estate taxes by placing the policies in an irrevocable trust. Though the trusts offer tax advantages, they have limitations as well. The insured must transfer ownership of the policy to a life insurance trust, which becomes the beneficiary of the policy. The insured cannot self-trustee and must give control of the trust to a trustee of his or her choosing. Policy holders can designate the beneficiaries of the trust, who are typically spouses and children, but cannot change beneficiaries once the trust is set up. As such, the trusts take away a policy holder’s ability to change beneficiaries in response to changes in circumstances and relationships.
The policy holder also loses the ability to borrow against the policy. What’s more, if policy holders die within three years of setting up the life insurance trust, the death benefit will be counted toward the estate. Premium payments can be counted against gift tax exemptions, but special provisions, such as those contained in a Crummey Trust, can help shelter premium payments from gift taxes.