Don't Pay Estate Taxes on Your Life Insurance

Part 3 of Vern's series on estate planning also examines personal residence trusts.
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Why pay the government a bonus for the privilege of having life insurance?

That's what you'll be doing if you don't plan ahead. The government always has its hand out asking for your money, especially after you die, so don't forget that life insurance is part of your taxable estate.

Last week, I explained that an individual with an estate worth up to $650,000, or a married couple with one valued at up to $1.3 million, can eliminate estate taxes using a credit shelter trust.

But what if you have an insurance policy in addition to those amounts? For instance, if you have $100,000 of insurance, up to half of that could become an unintended and unearned bonus to the

Internal Revenue Service

in the form of estate taxes.

Maybe you don't have any life insurance yet, but you might decide to buy some to cover one of the needs I discussed in my May 5 column,

Calculating Your Life Insurance Needs. If so, you may want to consider using an irrevocable life insurance trust, or ILIT, to save some estate taxes.

That word "irrevocable" is a little scary because once you do it, you can't change it. That is why most people who use it are generally older than 50. If you are younger, you may want to suggest an ILIT to your parents.

The concept of the ILIT is pretty simple. The insurance trust owns the life insurance policy for you. Since you do not personally own the insurance, it will not be included in your estate. There are always three parts to the ILIT:

  • You, as the grantor, create the trust.
  • The trust is managed by a trustee you select.
  • You appoint the beneficiaries of the trust.

In other words, you control the trust by creating a set of instructions the trustee must follow. The assets in this trust will bypass your estate and your spouse's estate and go directly to your kids (or whomever you name as beneficiary). This avoids estate taxes in both estates, saving a high percentage of your insurance proceeds. Proceeds in the trust can be used to pay estate taxes, pay for your children's or grandchildren's education, or be earmarked for almost any other purpose.

To pay the annual premium of the life insurance, you can make annual gifts to the trust on behalf of the beneficiary. You can give up to $10,000 ($20,000 for a couple) annually to each beneficiary. The trust must give the beneficiary the right to pull the money out each year, but since they would understand the intent of the trust, they probably wouldn't exercise that right. Another quirk in the law worth noting says the trust must be in effect for three years prior to your death or it is thrown back into your estate.

Estate Taxes and Your Home

Can you use your home to decrease your potential estate taxes? Yes, you can, and that also applies to a vacation home.

The concept is called a qualified personal residence trust, or QPRT (pronounced Q-Pert).

A QPRT allows you to give your home to a trust, while continuing to live in it rent-free for many years. According to White Plains, N.Y., estate tax attorney Neil Lubarsky, a QPRT can usually be structured to reduce the value of your house for estate tax purposes by at least two-thirds from its current value.

For this trust, you must pick a term and you must live for the full term of the trust, or the home will be put back into your estate. At the end of the term, the kids -- or whoever the beneficiary is -- own the house. If you want to continue to live in it, you have to pay at least 80% of a fair market rent to your kids. You are probably saying, "Are you crazy? Pay rent on my own home, to my kids?" Well, this obviously isn't for everybody, but hear me out.

If you own a house valued at $500,000, the remainder interest would approximate $160,000 in a 10-year QPRT. A remainder interest is the value of the property when it goes into the trust, after deducting various items, including the present value of your right to live in the house for the duration of the trust. You would have to pay a gift tax on the $160,000. The gift tax can be avoided by using $160,000 of your $650,000 federal estate tax exclusion.

For estate tax purposes, you have effectively frozen the value of your home. If your trust is for 10 years, the market value of that home could easily rise to $750,000 or more in that period. But you would not pay any additional estate tax on the increase. The greater the rise in value of the home or vacation house, the greater the savings.

The term of the trust must be three years or more. The longer the term, the lower the "remainder interest." If you went out 20 years, the remainder interest in my example would be about half the $160,000. The catch is that you have to live to the end of the trust's term or it doesn't work. That is why a lot of people use 10 years.

Not sure you want to pay rent to the kids? It definitely makes it easier if you and the kids have a great relationship. Just in case, you can stipulate that you would have right of first refusal to rent, that they couldn't sell it until you die and that they would have to charge a fair rent. If you have a big estate tax problem, you can look at the rent as another way of reducing your estate and therefore, your taxes.

Just a reminder that these trusts are not something to attempt on your own. I've only scratched the surface, so you can more intelligently discuss these techniques with your attorney.

Have a great Christmas and holiday.

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at