Should You Consider Second to Die Life Insurance in Your Estate Plan?

If you are like me, you may have considerable amounts of your estate in IRAs. I have a traditional IRA (money went into it pre-tax so all money coming out is taxable as regular income) and a Roth IRA (which I had to fund using rollovers from the traditional IRA as my income was too high to contribute directly during my working years.

Currently the federal estate tax exclusion amounts are well above the levels of assets that my spouse and I have, so we aren’t (yet) too worried about our heirs paying estate taxes after we die. Plus, we are doing an annual gift to our grown sons each year (or nearly so) to help them out, and remove assets from our taxable estate.

But, the money in my traditional IRA will be taxed when it comes out. In just a few years I will need to start taking distributions, but at the likely year of my death, there may still be hundreds of thousands of dollars in it (all good and fine I know!).

I had planned on training my heirs to leave it in the inherited IRA so it could continue to grow tax free for as long as possible (for my adult son’s life expectancy at least or maybe even for my currently young grand-childrens life expectancy). This would have allowed the benefits of my IRA to stretch over several lifetimes.

However, proposed legislation, very likely to be passed, will eliminate this stretch ability. Heirs, in the proposed legislation (except spouses) will have to take distributions rather quickly and deplete the funds in the IRA totally within 5 years.

Since all of the funds will be fully taxable at that time, my heirs will get far less benefit from the hard earned funds in my IRA than I had hoped.

So, I am exploring ways to mitigate the income tax bite on those funds for my heirs. One option I’ve heard is to take out a second to die life insurance policy, hold it in an irrevocable trust (so the death benefit isn’t included in my estate for estate tax purposes) and make my heirs the beneficiary’s.

This is a complex estate planning topic and I’m not an expert so if you want to explore this, please consult your attorney or accountant.

What is second to die life insurance?

Typically this a whole life or universal life policy that pays out the stated premium only at the death of the second of two insured people. Premiums should be lower due to the fact that two people have to die before it pays the benefit.

Often, the policy is purchased by an irrevocable life insurance trust. Its trustee buys the policy, pays the premiums and manages the trust terms. You (as granter of the trust) provide the funding. By having the trust own the policy (and be the beneficiary), the money is kept out of your estate and won’t be counted towards any federal estate taxes you might otherwise owe.

Why have one?

Historically, second to die (or survivor) life insurance policies have been used to meet expected expenses at death. For instance, one might buy such a policy if you are likely to be subject to estate taxes (or don’t want heirs to have to sell the farm in order to pay those taxes) or if you want lessen the tax impact of IRA distribution rules on your heirs – as I am considering.

Who would benefit?

If you have a large IRA or other retirement fund that will likely still have significant assets even after you take distributions, your heirs might benefit.

If you have an estate that contains ill-liquid assets (real estate, family business, commodities, alternative assets like art or cars) that will likely owe estate taxes, your heirs might benefit.

If your heirs don’t want or need an annual gift from you, and you don’t need the excess cash and want to get it out of your estate, your heirs might benefit.

If your heirs are young or not good an money management, the death benefit is retained in the trust and distributed according to the trust’s terms (which could spread it out over years or whatever you want).

What caveats are there.

You need a really good life insurance company.

You want to make sure that the policy will be good for several decades (you do plan on living a long time – right?). You don’t want that policy to end due to the company going out of business.

You need a very competent trustee.

You need someone who can handle the details of keeping the policy in force and out of your estate, and who will be able to handle the eventual distribution out of the trust to your final beneficiaries.

You need significant assets to make it worthwhile.

There will be costs to create and administer the trust. You will need money or assets for the trust to use to pay the premiums.

Tax laws may change or be re-interpreted.

After creating the trust and keeping the premiums (which you probably won’t ever get back) paid, future laws may invalidate the entire concept and your death benefit may become subject to estate or other taxes somehow.

If you fund the trust with an existing life insurance policy it may still be taxable.

If you die within three years of transferring your existing life insurance to the trust, Uncle Sam will still include the death benefit in your estate for estate tax purposes.

You have to keep the policy in force until the second death.

Your premiums may rise so much that you or your surviving spouse may not be able to keep the trust funded well enough to keep the policy in force.

Once you fund the trust, you can’t change your mind and get the money back.

It is, after all, irrevocable.

What kind of costs are there.

Accountant fees.

You will most likely need to pay an accountant to run the numbers for estate planning for you to see whether or not this type of plan makes sense for you.

Legal fees.

A lawyer is needed to set up the irrevocable life insurance trust (ILIT) so that it meets all the laws necessary to protect the death benefit from taxes.

Premiums.

Since you and your second insured are probably not spring chicks any more and since you want to buy a hefty amount of death benefit to make it worthwhile (think a million or more), premiums will be high.

Not only that, but if you get some kinds of policies the premiums may go up significantly after your trust buys the policy.

Trustee fees.

If you hire someone to be trustee on the trust, you will have to pay them.

Trust taxes.

Once the payout occurs (or if the trust earns money some other way) most of the income will be taxable at the very highest tax rates. In 2014, a person would have to make around $400,000 to be in the very highest tax rate, a trust only has to have income of around $12,000 to be in that rate.

How should you set it up?

Fidelity article Can life insurance help your estate plan? has this to say about setting one up:

“While an ILIT can provide a number of potential tax advantages, creating one is not a decision to be entered into lightly. A trust is a complex legal arrangement whose creation requires professional assistance, and it is most effective when in place prior to buying the insurance. The trust is irrevocable and once it is set up, you cannot terminate it, make changes to it, or withdraw the assets.

Typically, premium payments for a policy owned by the ILIT are funded by gifts made by the donor. To make sure that such gifts qualify for any available annual exclusions from the gift tax, beneficiaries of the ILIT are often given a short window after a gift is made—30 days is common—during which they may withdraw their share of the gift, up to the annual exclusion amount (in 2014 and 2015, the annual exclusion amount is $14,000 per beneficiary). Actual withdrawal of the gift by a beneficiary could defeat the ILIT’s ability to use the gifted funds to make premium payments on the policy, so beneficiaries must understand the overall estate planning goals for this approach to be fully effective.

One thing to keep in mind if you are considering single premium life insurance is that you will be creating a modified endowment contract (MEC). A MEC will receive less favorable income tax treatment when loans or partial surrenders are taken from the policy during the insured’s lifetime than a life insurance policy that is not a MEC. However, death benefits are taxed the same way for MECs as for policies that are not MECs. Most ILITs are funded through the purchase of a new policy rather than through the gift of an existing policy. If an existing policy is gifted to the ILIT, the insured must survive for three years after the gift before the assets will be excluded from the insured’s estate for estate tax purposes. In comparison, if funded through the purchase of a new policy, proceeds of the policy will not be subject to estate taxes in the insured’s estate, even if the insured dies immediately after the ILIT’s purchase. “

How to fund the trust.

If you typically give annual gifts to your beneficiaries, you might take part of that money and give it to them via the trust.

If you have gobs of money and want to take advantage of 2015 gift exclusions ($5.43 million each) from estate tax calculations, you can do an all at once gift to the trust of that amount. Just keep in mind that the money is gone for good from your control.

If you don’t need the required minimum distribution amount from your IRA, you could use that to fund the trust each year (by the way, it may be better to wait until towards the end of the year to take that RMD so that the funds grow tax free for most of the year in your IRA).

You might consider using an existing whole life or universal life policy to fund it.

How your heirs use it.

Once the second person dies, the trustee lets the life insurance company know and the policy pays the death benefit to the trust. The trustee of the trust then trades money for hard assets in your estate (or lends your executor the money) so that the estate can pay its taxes.

Then the trustee distributes the assets in the trust to the trust beneficiaries according to the way you as the trust granter specified when you created the trust.

Bottom line, your heirs get to keep the farm or have enough money to pay the income tax on the 5 years of distributions from your IRA.