Life Insurance Trusts
Perhaps the two most common reasons an individual buys life insurance is to make up for lost income for their spouse if they were to die and/or to pay potential future estate taxes. In other words, life insurance often serves as a couple's or individual's safety net. Unfortunately, most people think life insurance payouts are tax free. That's not entirely true.
While the surviving spouse or child (or anyone for that matter) receiving a life insurance payout upon the death of a loved one does not have to pay personal income tax on the proceeds received, the payout is, in fact, part of the deceased's taxable estate. Thus, under today's estate tax laws, estates in New York State with a taxable estate exceeding $3,125,000 million in value, including the value of the life insurance policy, face New York State estate tax. For example, if an individual passes away with more than a $3.2 million taxable estate, including $1 million in life insurance, his or her's estate could face a New York State estate tax. (The New York estate tax rates vary from 5 percent to 16 percent. However, because of the so-called "cliff" policy, if the value of the estate exceeds the exemption amount by more than 5 percent, an estate tax is due on the entire value of the estate.)
The individual could eliminate that estate tax entirely (or reduce it if their taxable estate is larger), by establishng a life insurance trust and having the trust own the life insurance policy. This is how it works:
When an individual buys life insurance, they traditionally own the policy. They pay the premiums. They can change the beneficiary designations whenever they like. If an individual establishes a life insurance trust before purchasing a life insurance policy and then has the trust purchase the life insurance policy, the trust, not the individual, owns the policy. The individual has no so-called “incidents” of ownership, because the insurance premiums will be paid out of the trust and the individual no longer has control over the trust because the trust is irrevocable. This means the terms of the life insurance policy cannot be changed.
Likewise, if an individual already has life insurance and wants to remove it from their potential taxable estate, they can establish a life insurance trust and then transfer the life insurance policy into the trust, which changes the ownership of the policy from the individual to the trust. When this is done, the individual must survive for at least three years beyond the transfer date for the policy to be removed from an individual's taxable estate.
In most cases, the trust will allow the surviving spouse to receive income from the trust and some or all of the principal, if it is needed. However, if the funds remain in the trust until the second spouse dies, the assets will pass through the trust to the couple's heirs, free of estate taxes. This would allow the assets to be used to pay other estate taxes that might be owed by the estate. Without these proceeds passing through the life insurance trust, they could be subject to estate taxes themselves and reduce their availability to pay other estate taxes.
With estate taxes in New York State starting for estates valued at more than $3,125,000, individuals with total
assets exceeding that amount in New York State, including the value of their life insurance policy, should strongly consider having a life insurance trust own their life insurance policy. The savings could be tens of thousands or hundreds of thousands of dollars in New York State estate taxes.
Likewise, if an individual’s assets exceed $5.43 million (or a couple’s exceeds $10.86 million), then removing life insurance from an individual’s taxable estate also could reduce federal estate taxes. If that is the case, the savings could be even far more, because the federal estate tax rate is as high as 40 percent, compared with a much lower tax rate for New York State.