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Can life insurance help your estate plan?

Consider a strategy that aims to provide flexibility and manage taxes.

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Ben Franklin said that in this world nothing is certain but death and taxes. Well, one product sits at the intersection of both—life insurance. It may not help you cheat death, but it may help manage taxes.

There are certain estate planning steps we should all take, including the creation of a will and a health care proxy. But if you have enough wealth that you expect your estate to be taxed—at either the state or the federal level—you may want to consider more advanced strategies, including using life insurance in a trust.

Life insurance—typically in the form of a universal life or whole life policy—can help families provide funding to pay estate taxes and provide other benefits for protecting wealth. “You may want to look at an irrevocable life insurance trust (ILIT) as an advanced planning technique that can offer a variety of benefits,” says Kimberly Rosati, wealth planning consultant at Fidelity. “It’s a good way to provide a source of ready cash for heirs to pay estate taxes on illiquid assets, such as property or businesses; or to allow wealth to pass to your heirs outside your estate.”

Providing flexibility to heirs

Estate tax strategies to consider

In 2015, the federal estate tax exclusion increased to $5,430,000 per person or $10,860,000 for a married couple that takes advantage of portability. There may be a lower state estate exemption amount in your state. As a result, you may have a state estate tax liability but not a federal estate tax liability. If your estate may owe state estate taxes, federal estate taxes, or both, it may make sense to consult your tax adviser and estate planning attorney about an ILIT.

One of the main reasons people set up an ILIT is to help provide their heirs with flexibility in settling their estate. A difficulty heirs often face is a lack of cash to pay estate taxes. (The top federal estate tax rate for 2014 and 2015 is 40%. Also, a number of states impose separate state inheritance and/or estate taxes.) As a result, heirs may be forced to sell real estate, stocks, or a family business to raise cash.

Aside from being an administrative headache to accomplish in the nine months before estate taxes are due, selling assets can present problems. Your heirs may want to keep the home, jewelry, or other assets you have passed on but be forced to sell them to raise cash. Or the timing could be inopportune—a slumping stock market or depressed real estate values could force the estate to liquidate assets at low values. Another hazard of a forced sale is the potential to trigger income or capital gains taxes—in essence, forcing your heirs to pay additional taxes in order to settle the estate tax bill.

A key advantage of an ILIT is that if the trust is set up and administered correctly, the assets owned by the ILIT will not be considered part of your estate for inheritance/estate tax purposes —meaning your heirs won’t have to pay estate or inheritance taxes on them. Premiums on the life insurance policy are paid by the trust, which means that the grantor must transfer sufficient money into the trust or pay directly on behalf of the trust to cover them. For 2015, gifts beyond the $14,000 annual exclusion from the federal gift tax reduce the federal lifetime gift and estate tax exclusion, currently set at $5,430,000 per person, and tax estates over that amount at a top effective rate of 40%. The reason insurance helps is because an ILIT uses gifts made to the trust to pay for insurance premiums. These gifts are removed from the estate, and the benefits paid out to your heirs will not be included as part of your estate for tax purposes.

Another potential tax advantage of an ILIT—and of life insurance in general—is that a death benefit is not considered taxable income by the IRS. Contrast that to an inherited individual retirement account (IRA), where assets are withdrawn according to minimum required distribution rules, and the heirs have to pay income tax on the distributed gains from the IRA.

While an ILIT can provide a number of potential tax advantages, creating one is not a decision to be entered into lightly. A trust is a complex legal arrangement whose creation requires professional assistance, and it is most effective when in place prior to buying the insurance. The trust is irrevocable and once it is set up, you cannot terminate it, make changes to it, or withdraw the assets.

How an ILIT works

An ILIT is an irrevocable trust that purchases a life insurance policy on the person who set up the trust, called the “grantor.” If a couple sets up the trust jointly, the policy is usually a “survivorship” or second-to-die policy, so the death benefit isn’t paid until both spouses pass away. It is important to note that the person must be insurable in the case of an individual policy; in joint policies, only one person may be required to be insurable.

When the grantor (or the surviving spouse) dies, the proceeds from the insurance policy flow into the trust and are eventually distributed to the trust beneficiaries, often the grantor’s children, grandchildren, or other family members.

How the money in the trust is paid out to the beneficiaries depends on how the trust is structured. The beneficiaries might be able to access the money soon after the insured person’s death, or the trust assets could be paid out incrementally by the trustee over time.

Making a gift count

Typically, premium payments for a policy owned by the ILIT are funded by gifts made by the donor. To make sure that such gifts qualify for any available annual exclusions from the gift tax, beneficiaries of the ILIT are often given a short window after a gift is made—30 days is common—during which they may withdraw their share of the gift, up to the annual exclusion amount (in 2014 and 2015, the annual exclusion amount is $14,000 per beneficiary). Actual withdrawal of the gift by a beneficiary could defeat the ILIT’s ability to use the gifted funds to make premium payments on the policy, so beneficiaries must understand the overall estate planning goals for this approach to be fully effective.

Choosing insurance

For the life insurance within the ILIT, you can use term life insurance or a form of permanent insurance, including whole life or universal life. However, many people choose permanent life, in part because the primary purpose of the ILIT is to transfer wealth to your heirs, which will only happen if the policy is still valid. If you outlive the term of your policy, the ILIT is essentially worthless.

“Term life is great for income replacement during your working years, but it’s generally not suitable for a permanent need such as estate planning,” says Tom Ewanich, vice president and actuary at Fidelity Investments Life Insurance Company.

Many companies won’t issue a term policy past a certain age, so a level-term period will typically not go beyond age 80. A universal or whole life policy, on the other hand, can provide a level premium for life.

Universal life policies are generally more flexible in design than whole life policies. For example, while whole life policies do provide a guaranteed death benefit, they also generally accumulate significant cash value that can be accessed during the insured’s lifetime. But if your main goal is estate planning and you are focused on a guaranteed death benefit, then universal life may be the preferred choice, as those policies can often be designed to be less expensive than whole life.

One thing to keep in mind if you are considering single premium life insurance is that you will be creating a modified endowment contract (MEC). A MEC will receive less favorable income tax treatment when loans or partial surrenders are taken from the policy during the insured’s lifetime than a life insurance policy that is not a MEC. However, death benefits are taxed the same way for MECs as for policies that are not MECs. Most ILITs are funded through the purchase of a new policy rather than through the gift of an existing policy. If an existing policy is gifted to the ILIT, the insured must survive for three years after the gift before the assets will be excluded from the insured’s estate for estate tax purposes. In comparison, if funded through the purchase of a new policy, proceeds of the policy will not be subject to estate taxes in the insured’s estate, even if the insured dies immediately after the ILIT’s purchase.

The projected tax liability of the grantor’s estate and the character of estate assets are the primary factors in deciding how much insurance to purchase. An ILIT provides the money to cover the taxes and gives the executor the flexibility to dispose of assets when it’s most advantageous to the heirs. It can also be a means to transfer sums of money to a particular beneficiary. The ILIT itself does not directly pay the taxes, but, rather, it can lend money or purchase assets from the estate.

Important considerations

Strength of issuer. “Because an ILIT could be in force for 20 years, 30 years, or even longer, it’s vital for the grantor to have confidence that the issuer of the life insurance policy is a solid company and not likely to go out of business,” says Robert H. Brown, a senior vice president at Fidelity Investments Life Insurance Company.

“The long-term nature of a life insurance contract means that customers should also be concerned about the long-term quality of the company issuing the policy,” Brown says. “You may get a cheaper rate quote from one company or another, but remember that comparing companies’ credit ratings is crucial. Try to balance getting both a low rate and a high-quality company.”

The right trustee. Choosing a trustee to administer the ILIT is also an important consideration. Because of the crucial nature of paying premiums in a timely fashion to keep the policy in force, and handling details such as notifying beneficiaries when money is contributed to the trust, an experienced trustee is vital.

“You’re not going to get younger, so you’re probably not going to get a better rate for your policy than at the age you are right now,” notes Rosati. “If you think you could benefit from an ILIT, talk to an estate planning attorney to explore the strategy in greater depth.”

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The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity does not assume any obligation to inform you of any subsequent changes in the tax law or other factors that could affect the information contained herein. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Universal life products available at Fidelity are issued by third-party insurance companies, which are not affiliated with any Fidelity Investments company. These products are distributed by Fidelity Insurance Agency, Inc. A contract’s financial guarantees are solely the responsibility of and are subject to the claims-paying ability of the issuing insurance company.
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