Many people falsely assume that because life insurance death benefits are generally income tax-free, a life insurance policy is out of the reach of the Internal Revenue Service (IRS). However, when a personally owned policy’s death benefits are added to the current market values of your home, business and other investments, it may come as a surprise to learn that the value of your estate exceeds the $2,000,000 exclusion amount for 2007. Fortunately, there are options available that can exclude life insurance from an estate.

Taxpayers should know that federal estate taxes are scheduled for a full repeal in 2010 thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). However, EGTRRA contains a sunset provision, which effectively reinstates the prior regulations in 2011 unless Congress acts in the interim.

Although the unlimited marital deduction allows you to pass an unlimited amount of property to your spouse free from estate tax, when the second spouse then dies with an estate worth more than the exempted amount, their whole estate would be subject to estate tax. Meanwhile, the first spouse's estate tax credit was unused and, in effect, wasted.

Option A: Bypass Trust

The bypass trust, also referred to as credit shelter trust, was created to take care of this problem. Upon the death of the first spouse, a separate, irrevocable trust is funded with the deceased spouse's share of the trust's assets. The surviving spouse is the beneficiary of this trust, with any children named as beneficiaries of the remaining interest.

The irrevocable trust is funded to the extent of the first spouse's estate exemption. Thus, the amount in the irrevocable trust is not subject to estate taxes on the death of the first spouse, and takes full advantage of the first spouse's estate tax credit.

At the same time, special language is used in the irrevocable trust so that the assets in the irrevocable trust will not be included in the taxable estate of the beneficiary (i.e., the surviving spouse). Generally this involves giving the second spouse only limited powers to control the trust assets. Thus, the bypass trust is aptly named, as the assets in the irrevocable trust bypass the estate tax that would be assessed when the second spouse dies.

Option B: ILIT

When non-spouse heirs are the beneficiaries of a life insurance policy, and the goal is to exempt the policy from the estate’s total worth, an irrevocable life insurance trust (ILIT) is another option. Keep in mind, however, the term “irrevocable” means beneficiaries may not be changed and loans may not be taken from the policy once it is placed into the trust. Purchasing a sizeable life insurance policy via such a trust could help beneficiaries finance the purchase of a family business or provide liquidity for estate taxes. In many cases these gifts can be made using your annual gift tax exclusion, thereby avoiding gift taxes.

You can also transfer existing policies to the trust. Keep in mind, however, that you must live at least three years following the transfer or the death benefit will be considered part of your taxable estate and the value of the policy on the date transferred will be considered a gift.

Planning with trusts can help reduce or defer taxes on high-value assets such as a life insurance. With the flexibility of trusts, however, comes complexity. It is important to consult with an attorney who is experienced in estate tax matters before proceeding.

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