A Few of the Basics

As an estate planning tool life insurance has become an attractive alternative to provide necessary liquidity for estate taxes. The challenge is nobody knows what is going on with the estate tax.

For instance, under current estate tax law there is NO estate tax in 2010. With that said Congress has hinted at a number of policy changes that may make the estate tax retroactive to January 1, 2010. On January 1, 2011, under current law, the Economic Growth and Tax Relief Reconciliation Act of 2001 sunsets to 2001 limits unless further legislation is enacted.

What does all of this mean?

In 2011, the estate tax unified credit exclusion reduces from $3.5 million in 2009 to $1 million per individual in 2011. If a husband and wife have an estate in excess of $2 million they would be subject to an estate tax of 50 percent on any amount exceeding $2 million.

Assuming you are worth $5 million your heirs would owe estate taxes of $1.5 million ($5 million less $2 million exemption times 50 percent). Do you know where the $1.5 million is going to come from?

Alternatively, unless properly structured, any life insurance you currently own will likely be included in your taxable estate. In the example above, if each spouse had life insurance of $1 million their estate would be valued at $7 million. Under this scenario the estate tax owed would be $2.75 million.

By taking a couple of simple steps much of the estate tax can be reduced, and in some cases eliminated. First, the family should setup a living trust to make sure they are able to take advantage of the $1 million unified credit per individual. Second, by structuring an irrevocable life insurance policy to own and be the beneficiary of the life insurance policies would prevent the policy proceeds from being includable and subject to estate tax (make sure you make annual gifts of premium payments utilizing Crummy Letters).

The result of these two simple steps would guarantee your first $2 million of assets are not subject to estate tax. The second step would result in the two $1 million life insurance death benefit being estate tax excludable. In other words, an additional $2 million of assets would not be subject to estate tax (that’s $4 million estate tax free). The remaining $3 million of assets would be subject to estate tax of 50% or $1.5 million. This would result in a net $5.35 million transfer to surviving beneficiaries.

With all this being said the estate planning community has many differing opinions on what direction Congress is going to take with the estate tax. Many practitioners are hopeful the unified credit stays at $3.5 million per individual. If this ends up being the case, properly structuring a living trust in the above mentioned example would be sufficient enough to transfer the entire estate tax free. Life insurance would not be necessary.

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