life insurance trust/ownership/beneficiary to keep proceeds out of estate

[george2010]

What is the name of your state (only U.S. law)? TX

I'm trying to come up with a clever way to keep life insurance proceeds out of either my estate or my spouse's estate, regardless of which order we die in. I know this could be accomplished with a irrevocable life insurance trust which both owns and is the beneficiary of the policy, but I don't really want to go to that trouble if I can avoid it.

I'm only talking about term life insurance that will last 10 years from now when I will only be 57 and my kids will all be done college. So this is not a case where there is a huge cash value that I am trying to protect.

My idea is this:
1. I will own my spouse's term insurance, and she will own mine. We will have to document that each is owned as separate property, since otherwise in Texas the policies would be assumed to be community property.
2. Now the tricky part that I'm not sure works: In my will, there will be a provision that creates a testamentary "Life Insurance Proceeds Trust", with my kids as beneficiaries, that will receive the proceeds from the life insurance policy that my spouse holds on my life. So if I die, the policy that she owns on my life pays the proceeds into the newly created Trust. My hope is that the proceeds will not be part of my estate, because my spouse owns the policy. But the strange part is that the trust is created by my will, and the trustee is appointed by me, so I want to make sure that my structure wouldn't backfire and result in the life insurance proceeds being viewed as part of my estate, despite my wife owning the policy.

Any opinions/suggestions?

 

[curb1]

First question is why do you want "to keep life insurance proceeds out of either my estate or my spouse's estate"? Especially, since "this is not a case where there is a huge cash value that I am trying to protect".

 

[george2010]

I should have been more clear: what I mean is that the life insurance policy itself is term insurance so it doesn't have cash value (as opposed to whole-life or other forms of insurance that have significant cash value). My estate will be >$7 million, i.e. high enough to trigger estate taxes under most scenarios envisioned beyond 2010. With possible estate tax rates as high as 55%, there is a huge incentive to find ways to keep assets out of my or my spouse's taxable estate.

Setting up an irrevocable life insurance trust (ILIT) can accomplish the task, but it seems likely to be a waste of time and money because the highest probability outcome is after spending all the fees to set up the trust and maintain it for 10 years, the term insurance will expire without ever using the trust. It really seems to me that the ILIT is more appropriate for insurance that has cash value, because eventually the trust will accomplish the goal. I may even decide if estate tax exemptions really do drop to $1 million next year that a whole-life policy inside an ILIT might be a good idea for me, but for now I'm sticking with just term insurance.

So I've been trying to come up with a scenario that only kicks in if I actually die during the term of the policy. In that case, I want the life insurance proceeds of a policy owned by my spouse (& therefore not part of my estate) to go into a spendthrift trust with my kids as beneficiaries, but with my spouse having a lifetime income interest. This would function much like the common "credit shelter trust" in terms of providing income to my spouse without the assets being considered part of her estate. So when she dies, the money would end up in my kids hands without ever having been part of either my estate or my spouse's.

The plan I outlined below is my attempt to accomplish that, but I'm suspecting there's a flaw otherwise my Googling would have turned up someone who was already using this arrangement.

Looking forward to any opinions about whether it will work.

 

[curb1]

Just curious, why do you need life insurance with $7 million in assets? I dropped all life insurance after passing the $2 million mark. I figured wife would be fine with $2 million and kids out of college.

 

[george2010]

I may well be over-insured at this point, but I like the fact that life insurance pays out quickly to the beneficiaries, who otherwise might have to wait months if not years to get the proceeds from my estate, especially considering that a significant portion of the assets would be difficult to value and difficult to liquidate quickly. I had an Uncle who's estate took over four years to be sorted out, with property and investments in four different countries subject to crazy probate and tax treaty issues. Meanwhile, his daughter was in limbo, paper-rich, but actually having trouble paying her bills. My estate isn't that complicated, but it isn't trivial either, so I like the assurance that if I have a kid in medical school when tragedy strikes that he/she won't have to worry about cash flow while the wheels of estate administration grind slowly forward.

Anyway.... back to my question... does anyone have any thoughts about whether my proposed structure will work? if not, suggestions for alternatives?

 

[Kiawah]

Neither a lawyer, nor financial advisor....but with that size estate you need to be gifting the cash over to the kids NOW, from both your wife and you, annually to each kid.

You can set up irrevocable trusts for them now, gift as much as you want to start with (can gift even more than the 13K x 2 if you fill out a form 709). If I'm checking out the grass roots earlier than I've planned, they're all ready set and the brokerage account is readily convertifble to cash to cover any immediately needed expenses....as well as growing for the long haul.

Revocable trusts can handle spouse expenses and the rest of the estate.

That would achieve your goal of getting money out of the estate (when you fund the irrevocable trust it's out immediately, put 200K now in each), and that would easily cover their college expenses at Duke should something happen in the next 10 years.

Those irrevocables then can also become the repository of any grandparent gifting. If you coordinate grandparent estate planning as well, you can also achieve a little bit of generation skipping. They can pass a certain amount of assets to your kids, bypassing you and avoiding a generation of taxation (there's limits).

Get yourself to a financial planner and good estate lawyer, you need to be thinking longer term than 10 years, and have a more comprehensive plan.

 

[george2010]

Thanks Kiawah for your excellent input... I'm completely on board with your train of thought and already have a gift plan in place. I have a good estate planning attorney who I am currently working with to do a complete rework of my estate and asset protection plans. So my purpose in posting this question wasn't really to get into a broad discussion of my estate plan: it was to try to get some input on this very specific issue of setting up life insurance ownership and beneficiaries. My attorney offered only the ILIT option, but after Googling around it became apparent to me that with some creative assignment of ownership and beneficiaries I could get some of the benefits of an ILIT without any upfront costs or ongoing administration. One paper I read that gave me the key idea of having the policy pay into a testamentary trust was this one, written for military service members: http://www.lejeune.usmc.mil/legal/Testamentary Life Insurance Trust for Minors Rev 080916.doc
After reading that, I came up with the scenario in my original post. I'm meeting again with my lawyer later this week, so I can bounce the idea off him, but just asking the question will probably cost me another $300! So I thought I'd try to do some homework myself first, and if this is a stupid idea for some reason I'd rather find out now.
So, if anyone has any input about whether my proposed setup will achieve the goal of keeping insurance proceeds out of both estates, please let me know!

 

[tecate]

Did you think about whether the first payoff is a gift from the surviving spouse to the trust?

 

[george2010]

Did you think about whether the first payoff is a gift from the surviving spouse to the trust?

That's exactly the kind of issue I'm trying to identify. I know that a transfer of a POLICY into a trust would be viewed as a gift, but I don't think the payment of proceeds to a beneficiary, whether or not that beneficiary is a person or a trust, triggers any gift tax issues. Have I missed something?

 

[tecate]

Why is naming a beneficiary any different than naming yourself and paying over the proceeds?

 

[george2010]

Why is naming a beneficiary any different than naming yourself and paying over the proceeds?

Say policy is 1 M$. If proceeds go to me and I hold on to them until I die, they become part of my estate, taxable at probably 45 to 55% in 2011 or beyond -- call it $450,000 in estate taxes. If instead, I take those proceeds and immediately transfer them into an irrevocable trust for my kids benefit, then other than a $13,000 exemption, the transfer would be subject to gift taxes at 35% in 2010 but probably back up to the same 45-55% as estate taxes next year. Third option of having an ILIT trust own the policy and be the beneficiary results in the proceeds going 100% to the kids with no estate or gift taxes, so a savings of $450,000.

So the ILIT approach is the one that works for sure, but I understand the legal fees are likely to be $2000-$3000 (I'd be interested if anyone has actual cost data from their personal experience setting up an ILIT). You might think that is a low price to pay to save $450,000, but a much simpler and not much more expensive option is just to buy more life insurance, and let the IRS take it's cut. That approach would also save me hours of my time to setup an ILIT trust bank account, and get all the ownership and beneficiary designations correct. So I'm really not feeling like an ILIT is the right move for me.

But the fourth, holy grail option that I am floating here would result in a situation where I could get the benefits of the ILIT without any of the upfront costs. I'm still hoping someone with some expertise in this area will read this post and offer an opinion about whether it will work.

 

[Kiawah]

Don't overlook some other costs, and probabilities, in your decision tree analysis. A couple points:

- There is a cost to buy this term life insurance. There is some probability that you will die in the next ten years, and I would guess a much higher probability that you would live for the next ten years (unless you were headed to harms way or knew some other extenuating circumstances). As such, at the end of ten years, the cost of term insurance would be lost with no estate planning ROI.

- If you gifted 500K to an irrevocable trust now, that 500K would grow during the next ten years at some percentage. Just to run the numbers, if you assume 500K @ 8% @ 10 yrs the end value would be 730K (growth of $230K). If you are 45 now, if it grows to when you die at 80 it would be worth $1.8M (growth of 1.3M). None of that would be subject to estate taxes when you die, so there is substantial estate cost avoidance by gifting now. From an income tax rate perspective on the annual 1-3% ROI stock dividends, at the trust values we're talking about here, the tax rate would most likely be substantially less than your personal tax bracket (more tax avoidance). If some of the assets are withdrawn and used before you are 80 and die that growth is of course all subject to 15% capital gains income tax, but it would be the same whether you still owned it as your own titled assets, or whether the irrevocable trust owned the assets....so it's financially equal. The one downside is that you do loose the step up in cost basis which you would get if they were still part of your estate when you die at 80. As investment assets are turned over in the account however, the cost basis will track upwards over time. So it's now like the cost basis will stay at 500K.

With your estate situation, I don't think you want to loose 10 years of time.


Neither a lawyer or financial adviser, so please use professionals.

 

[george2010]

Thanks Kiawah... all good advice.

You're absolutely right about the high probability that the term life insurance will expire unused. That's why I'm so reluctant to go to the trouble and expense of establishing an ILIT to hold it. But if my proposal to improve the tax treatment simply through ownership and beneficiary designations works, then the upfront investment is close to zero, and it becomes a no-brainer.... so still hoping someone will comment on my original proposal!

re: your analysis of option to do a large gift now into irrevocable trust, there no doubt is some merit in options like that, but I've decided to wait until Congress does something to clarify the current estate/gift/GSTT tax mess before setting up anything irrevocable. Maybe now Obama has crossed health care off his list he'll find some time for estate taxes. One issue about your analysis of income tax savings -- I believe trust tax brackets hit max at only $11,150 of income, so chances are the trust and I will be in the same bracket. Plus I'm not sure the type of trust you are describing really would move the assets of the trust out of my estate, or whether it would even be considered a true gift, because to be a gift I think it has to be a "present interest" of the recipient. And if I make myself a lifetime beneficiary of such a trust (as suggested when you said "If some of the assets are withdrawn and used...") I think that pulls those assets right back into my estate. But I'm no expert in trusts, and may have misunderstood what kind of trust you were envisioning...

 

[Kiawah]

An irrevocable trust, moves assets out of your estate. You have no control over the assets anymore, your trustee does. You can't be a beneficiary, your child is. When I made the comment 'if some of the assets are withdrawn and used', I'm referring about the trustee making disbursements to pay for something like college. For instance if you die and funds are needed for college, trustee can pay for college with trust funds. If you are still alive and working, you can pay for college with your own checkbook.

You (and your lawyer of course) write the language of the trust as to when disbursements can be made, and under what circumstances, and the trustee executes it. You also write what latitude you give, or don't give, to the trustee in regards to disbursements. You can also write things like: when the child turns 30, they can withdraw up to 1/3 the value of the trust anytime after that date, when they turn 40 they can withdraw 1/2 of the remaining value of the trust after that date, and when they turn 50 they can completely withdraw. You (technically) are out of the picture once you gift assets to the trust.

I say technically, because your brother for instance could be the initial trustee, and they do make telephones.

Spend a couple hundred bucks, and buy the ElderLaw Forms Manuals (2 binder set) by Margolis, Aspen publishing. It's got a couple different sections on different kinds of trusts (with examples). If you read thru all of those different trusts, you should get a very good idea of the types of options you have. It should make your conversations with a lawyer very productive and to the point, and you won't be racking up unnecessary hours.

Re: taxes. Qualified Dividends and Longterm capital gains get favorable tax treatment. I've got a couple decent sized trusts (for each kid since they were born), and almost 20 years later they run typically in the 11-15% avg federal tax rate. Trusts with investment income is not like W2 income that gets you into the higher tax brackets. Form 1041, if you want to run some numbers.

 

[sam02135]

Neither a lawyer, nor financial advisor....but with that size estate you need to be gifting the cash over to the kids NOW, from both your wife and you, annually to each kid.

You can set up irrevocable trusts for them now, gift as much as you want to start with (can gift even more than the 13K x 2 if you fill out a form 709). If I'm checking out the grass roots earlier than I've planned, they're all ready set and the brokerage account is readily convertifble to cash to cover any immediately needed expenses....as well as growing for the long haul.

Revocable trusts can handle spouse expenses and the rest of the estate.

That would achieve your goal of getting money out of the estate (when you fund the irrevocable trust it's out immediately, put 200K now in each), and that would easily cover their college expenses at Duke should something happen in the next 10 years.

Those irrevocables then can also become the repository of any grandparent gifting. If you coordinate grandparent estate planning as well, you can also achieve a little bit of generation skipping. They can pass a certain amount of assets to your kids, bypassing you and avoiding a generation of taxation (there's limits).

Get yourself to a financial planner and good estate lawyer, you need to be thinking longer term than 10 years, and have a more comprehensive plan.

In your life time, you are allowed to gift $1 million dollars max with out "penalty"... then penalties kick in.

If I think I understand what you're saying, you want proceeds from your life insurance policy that your wife will be the owner to go to your children and vice versa. The problem is since your wife owns "your policy", you have no control of that money. She directs the money to whom she want. Unless she herself will setup a trust with the stipulations of "her money". And that would be a living trust.

If the IRS sees that the only purpose of moving assets is to prevent taxation, then they may revoke that. Look back is 6 years I believe now.