I received this question from L. W., of Glen Cove, N.Y., who wrote:

I've heard about irrevocable life insurance trusts. What can you tell me about these?

Dear L. W.:

I'm delighted to provide some information. There is a great deal to learn and here is an overview, presented in two parts.

With marginal rates starting at 37%, federal estate taxes are a great source of concern. Individuals facing the potential loss of more than half their life's efforts are turning to estate planning to get their wealth to the individuals they choose, in a way that reduces the impact of estate taxes and expenses. One way to accomplish this is with life insurance trusts, one of the most useful, if unromantic, tools in estate planning today.

Current tax law provides relief from estate taxes for many people. The lifetime credit, if not previously used to offset gift taxes, may be applied against federal estate taxes allowing the first $600,000 of taxable assets, which include both real estate and improvements, and personal property such as savings and investments, life insurance and retirement plan benefits, to pass to heirs free of federal estate taxes. Also, all assets and property left to a spouse can escape federal estate taxation through the use of the unlimited marital deduction (different rules apply for a non-citizen spouse. So, with a properly arranged estate plan, a husband and wife might leave $1.2 million estate tax-free to the next generation. The problem arises for individuals with more than $600,000 of assets, or married couples with greater than $1.2 million upon the death of the surviving spouse, when current federal estate taxes are imposed first at a 37% marginal rate and depending on the estate size, climbing to 55%. When more than half of all assets can be lost to federal estate taxes, the advantages of life insurance trusts make them an attractive tool for the affluent to pass wealth to their family. A life insurance trust combines a life insurance policy with an irrevocable trust.

One advantage of life insurance is that the death benefit is paid at the exact time it is needed. Also, this cost-effective vehicle is usually received by the beneficiaries income tax-free. But, if the deceased had any current ownership rights in the life insurance policy ("incidents of ownership"), its proceeds may be included in his or her taxable estate and subjected to estate taxes. This can have the effect of naming the IRS as a silent beneficiary and reduces the value of the life insurance death benefit. One way to escape the estate tax bite is not to have any incidents of ownership. This is where the irrevocable trust comes into play.

An individual can transfer ownership of existing life insurance policies into an irrevocable trust. Or, and this is the better solution, the individual may set up such an irrevocable trust and give the trustee the power to purchase a new life insurance policy using trust assets. The individual then makes cash gifts to the trust for the benefit of the trust beneficiaries. The trustee is given the power to use this money to pay any future premiums that are due on the policy. When properly structured, the trust owns the policy and not the insured individual, so the policy escapes estate taxation. An important caveat, if an existing policy is transferred to an irrevocable trust and death occurs within three years of the transfer, the proceeds will be included in the insured's estate.

Next issue - gift tax consequences; use of proceeds; additional caveats.

This is the second of two parts on the question from L. W. about irrevocable life insurance trusts.

In the first part I talked about federal estate taxes possibly depleting more than half the estate's assets. I reviewed several ways for reducing those taxes including use of the lifetime credit and the unlimited marital deduction but this left issues for individuals with more than $600,000, or married couples with greater than $1.2 million upon the death of the surviving spouse. I said the irrevocable life insurance trust, while unromantic, was an attractive tool to pass wealth to your family.

I named several advantages, including the death benefit paid at the time it is needed and usually received by the beneficiaries income tax-free, and that the policy is cost-effective. I said to be careful of retaining any "incidents of ownership" and to use the irrevocable trust by transferring-in existing policies or, better, empowering the trustee to purchase a new policy using trust assets. When properly structured, the trust, not the insured individual, owns the policy, so it escapes estate taxation.

Compared to other assets such as stocks or real estate, life insurance policies and premiums generally have a low value for gift tax purposes, so the payment of gift taxes may not be required when the policy, or premiums to pay for the policy, are transferred into the trust. Yet the life insurance proceeds, or death benefit, can be many times the premiums gifted, and since life insurance is usually viewed as benefitting the survivors, it may be easier for you to give it away compared to investment or other assets. While the trust can't pay the estate taxes of the deceased directly, it can purchase assets from the estate using the death benefit proceeds. In this way an asset, such as a business, may remain in the family, or assets that won't sell quickly or may sell at a loss, such as a house or stocks, still may go to the ultimate beneficiaries. In addition, the estate gets the cash it needs to cover estate taxes and other expenses.

While the irrevocable life insurance trust is an attractive estate planning option, it's not for everyone. The irrevocable feature that gets the policy out of the tax and probate estate, also prevents the individual from making any changes after establishing the trust. There are also costs to set up the trust, including legal, trustee, and accounting fees, and potential gift taxes due on assets transferred to the trust. But, for individuals facing significant estate tax rates, the advantages can outweigh the disadvantages.

The irrevocable life insurance trust may offer a cost-effective solution to estate liquidity needs because it helps provide funds to pay taxes for the estate, rather than from the estate.

This two-part article has presented an overview of irrevocable life insurance trusts. Due to variations in state law, and the complexities of these trusts and estate planning in general, if you are interested in an estate plan, you should talk to professionals who specialize in estate planning to help ensure the policy you purchase provides the benefits you intend.