Irrevocable Life Insurance Trust Case Study

The Problem Illustrated

Stan is single and has a small business worth $1.1 million, a home worth $250,000, a car worth $30,000 and has $20,000 in cash. If Stan dies in 2002, federal estate taxes on this estate of $1.4 million would amount to approximately $167,000. Stan decides to buy a $200,000 life insurance policy to provide the necessary liquidity. However, it is not that easy.

The life insurance increases the value of his estate from $1.4 million to $1.65 million, which in turn, increases the federal estate tax to approximately $277,000. The $200,000 policy will not be enough. Not only does Stan have to have additional life insurance to solve his initial liquidity problem of $167,000, he also has to buy even more life insurance to cover the additional tax cost associated with an increase in his estate that is caused by the additional life insurance. In this example, Stan would have to buy approximately $300,000 to $350,000 in life insurance to solve his liquidity problem.

The Life Insurance Trust Solution

A life insurance trust is a trust created by an individual (and sometimes their spouse) to own life insurance on the life of themself and/or their spouse. The advantage of using the life insurance trust, rather than simply owning the life insurance outright, is that the life insurance proceeds received by the life insurance trust at the individual’s death are not included in the individual’s estate.

A life insurance trust offers a solution to the spiraling estate taxes that result from increasing your life insurance. Instead of having to own additional life insurance directly, a separate life insurance trust is created to own the additional life insurance. Because the trust owns the policy, not you, the life insurance is not included in your estate.

In the above example, Stan would create a life insurance trust to own the additional life insurance of $200,000. Stan's estate would remain at $1.4 million and at Stan's death the life insurance proceeds would be paid to the trust. The trust would then make the proceeds available to the estate to help pay the federal estate taxes by making a loan to the estate or by buying a portion of Stan's business from the estate.

If you ever need help, speaking to an estate planning attorney is a smart idea. The cost of speaking to an attorney is worth it compared to the possibility of making a costly mistake.