Combining Trusts and Life Insurance to Avoid Tax

To minimize estate taxes, investors often transfer assets during their lifetimes to an irrevocable trust. Assets transferred to an irrevocable trust grow outside of the donor’s taxable estate, and thus pass to heirs entirely free of estate tax.

Although investment earnings of a properly structured irrevocable trust are exempt from estate taxes, those earnings are subject to income tax. In fact, an irrevocable trust pays income tax on virtually all of its earnings at the highest tax rate.

This Viewpoint discusses how investors may reduce income taxes imposed on an irrevocable trust while still using the trust to reduce estate and gift taxes due. In particular, the paper discusses how an investor can combine wealth transfer rules with the purchase of permanent life insurance to minimize taxes while transferring additional wealth to heirs.

The Power of Gifting

For 2014, the combined lifetime gift and estate tax exemption is set at $5.34 million per individual. Thus, a married couple can pass on a total of $10.68 million during life or at death without any gift or estate tax. (This amount is in addition to the gift tax exclusion that permits a donor to make annual gifts of up to $14,000 to an unlimited number of donees.)

The high lifetime gifting exemption provides a significant wealth transfer opportunity. If a donor gives away $5.34 million now, the gift can appreciate during the remainder of the donor’s life. By the time the donor dies, the gift may have increased substantially in value. Yet that full amount will be entirely free of federal estate tax.1

Typically an investor wishing to make a large gift to children or grandchildren will put the gifted amount in an irrevocable trust, rather than giving it to heirs outright. Use of a trust lets the investor control the later distribution of the assets, keeping them away from heirs who, due to youth or inexperience, might squander them.

Income Taxation of Trust Income

Virtually all investment income earned by an irrevocable trust typically is taxed at the highest tax rate. This rule is a significant — and adverse — departure from the tax rules governing taxation of individuals. An individual taxpayer is subject to the top tax rate only to the extent his or her taxable income exceeds $406,750 ($457,600 for a family). But an irrevocable trust is subject to the top tax rate on income in excess of only $12,500. Thus, while even affluent families avoid the highest income tax rate on a significant portion of their income, a trust must pay tax at that rate on virtually all of the income it earns.

An irrevocable trust is subject to the top tax rate on income in excess of only $12,150.

And that top income tax rate has increased significantly over the last few years. In 2012, the top tax rate on most dividends and long-term capital gains was 15%, and the top tax rate on other types of investment income was 35%. In 2013, the maximum income tax rate on most dividends and long-term capital gains was increased to 20% and the tax rate on other types of investment income to 39.6%. In addition, beginning in 2013 investment income became subject to an additional 3.8% surtax. When the surtax is added to the new higher regular tax rates, the tax rate on most dividends and long-term capital gains rises to 23.8% and the tax rate on other invest-ment income rises to 43.4%. Thus, the tax rates applied to virtually every dollar of irrevocable trust income have risen almost nine percentage points since 2012.

A trust can reduce income taxes by distributing investment income currently to a beneficiary. A trust pays no income tax on distributed income. Instead such income is taxed to the recipient at the recipient’s tax rate — which may be lower (and in any event cannot be higher) than the trust’s tax rate.

But reducing trust income tax by distributing income that beneficiaries do not need is inefficient and thwarts the estate planning purpose of the trust. Estate taxes are minimized where the trust retains its investment earnings so the earnings may later pass to final beneficiaries estate tax free. If trust income is distributed currently instead, the beneficiaries needlessly pay income tax and, later, estate tax when they fail to spend the income during their lives.

This, then, is the conundrum of trust taxation: To keep income taxes low, a trust should distribute its income. But to keep estate taxes low, a trust should retain its income and pass it on later to future generations. The conundrum can be solved only by accumulating earnings in the trust and investing assets wisely to minimize the income tax imposed on those earnings.

To achieve both estate tax and income tax efficiencies a trust should invest in assets that generate income exempt from tax or taxed at low rates. For this reason, when investing trust assets, a professional management strategy that seeks to enhance after-tax return by balancing investment and tax considerations is exceedingly important.

Life Insurance in an Irrevocable Trust

From a tax perspective, one of the best funding vehicles for an irrevocable trust is permanent life insurance, which can minimize both income and estate taxes while enhancing greatly the amount passed on to heirs. Increases in the cash value inside a life insurance policy are not subject to income tax. When the insured dies, the life insurance pays out a death benefit that is a multiple of the amount paid in premiums. And that death benefit is not subject to income tax. Thus, by investing trust assets in a life insurance policy, a donor can transfer significant assets to heirs entirely income and estate tax free.

One of the best funding vehicles for an irrevocable trust is permanent life insurance.

Irrevocable trusts funded with life insurance are so common they are given a special name: “ILITs”, or “irrevocable life insurance trusts.”

Life insurance also can provide needed liquidity to heirs when an estate holds assets that cannot easily be sold at full value, such as a family owned business. Without liquidity at death, heirs who otherwise would continue the family business might have to sell it to pay estate taxes due. The business owner’s purchase of life insurance through an ILIT can provide heirs with tax-free funds to offset the tax due on the estate, keeping the business intact.

To provide liquidity in the case of married couples, “second-to-die” life insurance is often used. A second-to-die policy pays at the death of the second spouse, when the estate tax is due. (The first spouse to die can escape estate tax by transferring assets to the surviving spouse; estate tax rules permit unlimited tax-free transfers between spouses.) Second-to-die insurance is typically less expensive than traditional life insurance.

A donor may fund the ILIT with an amount up to the lifetime gift tax exemption (currently $5.34 million) without triggering gift taxes. As an alternative, a donor may fund an ILIT with annual gifts within the annual gift tax exclusion amount (currently $14,000 per donee or trust beneficiary). These gifts are then used to pay annual premiums on the policy.

There are other means available to fund an ILIT. For instance, it may be possible to convert existing life insurance policies to a policy more suited to provide liquidity at a lower cost. A comprehensive life insurance review can uncover this potential.

Similarly, an investor might use required minimum distributions from an IRA (or other qualified plan) to pay the premiums on an insurance policy. Combining a life insurance purchase with an annuity might also make sense. An annuity can provide a guaranteed minimum annual cash flow. That cash flow can be used to pay annual premiums on a life insurance policy, without fear that the policy will lapse due to inability to pay the premiums in the future.

An ILIT must be carefully structured with professional assistance to assure that the donor does not retain excessive rights over the life insurance policy. Retention of such rights could cause the life insurance proceeds to be included in the donor’s estate.

Conclusion

Using irrevocable trust assets to purchase permanent life insurance can provide greater amounts to heirs while minimizing both estate and income taxes. Given the higher income tax rates in effect, now is the time to discuss these techniques with a qualified professional.

Some states have adopted — or have suggested they will adopt — a lower gift tax exemption amount for purposes of applying the state inheritance tax. Thus it is important to consider state tax consequences before undertaking any gift.

This information is not intended to be tax or legal advice, and it may not be relied 
on for the purpose of avoiding any federal tax penalties. You are encouraged to seek 
tax or legal advice from an attorney or independent professional advisor.