Who Needs a Life Insurance Trust?

If you are single and have a net worth over $1,000,000 (including life insurance proceeds upon death), or if you are married and have a net worth over $2.0 million (again, including life insurance), you should seriously consider a life insurance trust. Let us consider an example:

Let us say you are single, with a total net worth of $1,000,000. In addition, you own a $500,000 life insurance policy – a total estate of $1,500,000. Without a life insurance trust, the $500,000 of life insurance would be included in your taxable estate – and your estate would have to pay $210,000 in estate taxes.

On the other hand, if your $500,000 policy were instead owned by your life insurance trust, the $500,000 in insurance would not be included in your estate. Because your other assets would equal the $1,000,000 estate tax exemption($1,500,000 in 2003 and 2004, back down to $1,000,000 in 2011), no estate taxes would be due. That means that $210,000 would go to your beneficiaries, instead of to Uncle Sam., such as closely-held businesses, their home or other real estate. Under current tax law, if a person’s net estate exceeds the estate tax exclusion (unlimited in 2010 under present law, but then back down to $1,000,000 in 2011), estate taxes (federal and state) must be paid. We will assume the $1,000,000 estate tax exemption is in effect under the examples below. The estate taxes are very expensive – they start at 41% and quickly go up to 49%, depending on the size of the estate.

In addition, these estate taxes are due nine months after death – in cash. This can devastate many estates (especially those with small businesses or other illiquid assets). Such assets must often be liquidated instead of being preserved for the heirs.

On the other hand, to avoid forced sales, people often buy life insurance. However, if the insured owns the policy, the proceeds themselves will be subject to estate taxes. The net proceeds, after payment of estate taxes, will often only be half of the proceeds paid under the policy. For example, a $500,000 policy owned by the insured will often generate a $210,000 estate tax attributable solely to the insurance proceeds. Thus, only $290,000 of the proceeds will be available to the beneficiaries.

Surprisingly, through the use of a relatively simple and properly drafted life insurance trust, the insurance proceeds will not be subject to estate taxes. The full proceeds will be available to the beneficiaries, free of both estate and income taxes.