A life insurance policy can be an integral part of estate planning. The Wall Street Journal published a book on estate planning in 2011 (“The Wall Street Journal Complete Estate Planning Guidebook,” by Rachel Emma Silverman. Copyright 2011 by Dow Jones & Co. Inc.), and one section is on the multiple uses of life insurance. A partial list of those uses:
- move assets out of your taxable estate
- fund a Supplemental Needs Trust for a beneficiary receiving public benefits
- provide funds to for a buy-sell agreement concerning a business
- pay estate taxes
- pay off a mortgage
- pay for children’s college education
- provide income for daily needs.
With an Irrevocable Life Insurance Trust (ILIT), the trust is the owner of the policy on the grantor’s life, and beneficiaries are designated to receive the insurance proceeds when the grantor dies. Most commonly, the beneficiaries are granted “Crummey Powers” (named after a court case of the 1960’s), which means that the grantor makes a gift of money available to the beneficiaries and if they do not take advantage of the gift, the money is used to pay the insurance premiums. The amount of money is the annual gift tax exemption amount of $14,000 per beneficiary (valid for 2013 and 2014). The grantor gives up all control over the life insurance in the trust, and cannot change the terms of the trust. Thus the value of the life insurance is not counted in the grantor’s estate at death. The rationale for establishing an ILIT varies from reducing the estate subject to federal and/or state estate tax, to sheltering assets from creditors to providing tax-free income to beneficiaries.
People who have dependents with a permanent disability making them eligible for needs-based government benefits must take steps to protect that eligibility. Receiving an inheritance outright may result in disqualification from the needs-based benefits, with a long waiting period to requalify. A common way to avoid that disqualification is to leave an inheritance inside a Supplemental Needs Trust (also known as a Special Needs Trust), managed by a designated trustee for benefit of the disabled dependent. Life insurance can be a key way to fund the trust on the death of the grantor. The disabled dependent is most likely to need a permanent life insurance policy, making a term life policy affordable for a set period of years but with unaffordable premiums after the term expires, and the policy has to be renewed. A whole life or universal life policy with a guaranteed death benefit is usually a better idea. To control costs, it is possible to purchase a “second-to-die” policy that insures two people (usually the disabled person’s parents), and does not pay until the death of the second person. If the life insurance policy has been in existence for some years and has built up a cash value, the premiums can be paid from the accumulated cash value. Regardless of the type of insurance, the policy must name the designated trustee of the Supplemental Needs Trust as the beneficiary, not the disabled dependent beneficiary.
Small businesses frequently incorporate life insurance in a buy-sell agreement. Either the company or the individual co-owners buy life insurance policies on the lives of each co-owner, not on themselves. When an owner dies, the owner(s) of the policy, whether the company or the co-owner(s), receive the death benefits. The proceeds are distributed to the deceased business owner’s family to buy out the interest in the business. Insurance is a popular means to fund the purchase of a deceased owner’s share of the business because it makes a lump sum of cash available, relatively quickly after the death of a co-owner. The proceeds are generally not taxable as a refund of the premiums paid in. If the policy has sufficient cash value, it may be possible to tap to buy out a living co-owner who decides to retire. There are some drawbacks: the premiums must be paid for an extended period, and are generally not deductible as a business expense (the business and/or the co-owners are named as the beneficiary). If there is a significant difference in ages among the co-owners, the younger owner(s) will pay higher premiums for the older owner(s).