Estate tax laws are once again up for debate in Washington D.C. But no matter what the outcome of the negotiations will be - whether estate taxes will be repealed or reinstated after the year 2012 -estate planning should not be placed on hold. Your benefits will likely never be better than they are now. Currently, federal estate taxes are incurred on estates that are in excess of $5.12 million ($10.24 million if married) and these figures will fall to $1 million and $2 million in 2013. Preparing today for the efficient transfer of your wealth is a move that could pay off in the long run.
One tax-efficient way to pass along your wealth to heirs, with greatly reduced estate tax liability, is an irrevocable life insurance trust (or ILIT). ILIT's were created to shelter life insurance benefits paid to beneficiaries from estate taxes. Although life insurance benefits are not subject to federal income tax, they can be included in an estate upon the death of the policy owner and subject to federal estate taxes.
Here's how it works: as the estate owner, you create an ILIT and name a trustee to administer it. You cannot be named as the trustee, so it is sometimes advisable to name an attorney, CPA, trust company, or financial institution as the trustee for the ILIT. Also, at the time you create the ILIT, you name the beneficiaries and direct how the trust funds will be distributed upon your death. Then, you deposit money into the ILIT and you have the irrevocable life insurance trust purchase a life insurance policy, naming the trust as the beneficiary. Note that because of the high estate exemption in 2012, your tax-free (i.e. free of gift tax) transfers to the trust can be much larger than next year.
Upon your death, the proceeds from the life insurance policy will be paid to the ILIT, which will then distribute the funds as you directed in the trust documents. For example, you could state that one-half of the life insurance proceeds be paid to your beneficiaries at the time of your death, with the remainder paid out at a later date.
Your beneficiaries could also use the proceeds to pay the federal estate taxes or even the state inheritance taxes due on other assets they receive from your estate. This may be an ideal strategy for you if some of the assets in your estate are illiquid (e.g., real estate.)
The effectiveness of an irrevocable life insurance trust as an estate-planning tool is dependent on your insurability. If you cannot obtain a life insurance policy for health reasons, or if the policy is too cost-prohibitive, using an ILIT may not be available to you. Please also note that fees and other expenses will apply with the purchase of life insurance, and surrender charges may be applicable on money withdrawn or benefits reduced after the policy is purchased. Insurance benefits and premiums also vary from company to company. Insurance guarantees are subject to the claims-paying ability of the issuing company.
In conclusion, the irrevocable life insurance trust could prove to be an effective wealth-transfer strategy.