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Taking Care of Mom and Dad: Life Insurance Trusts

We hinted at life insurance trusts briefly in the beginning of this chapter when we said how taking out a life insurance policy on a parent is a way of insuring certain hard-to-value family assets -- like a business. More on this topic will be discussed in Chapter 12; but it's worth mentioning a life insurance trust here since it's a widely used but unfortunate name for an irrevocable trust used to buy insurance as an investment. (The trust can also be authorized to hold a range of investments, and not just life insurance.)

Remember that proceeds from policies your parents own will be included in their estate, even though the policies are paid to a third party. If an irrevocable trust owns the policy, however, death proceeds can be received by the family income tax free (as usual), yet not be included in your parents' taxable estate.

A trust is not necessary to get this result. If you -- as a son or daughter -- owns, pays for and is a beneficiary of a policy on the life of a parent, you can receive the policy proceeds with no taxes due. So, one of the smartest money things you can do as a son or daughter is fund estate taxes and other costs by taking out a policy on your parent's life. This may sound mercenary; but, if your parents have a big estate, it's smart.

Trusts that hold insurance provide for the use and management of the policy proceeds according to one's wishes. The beneficiaries might not be old enough to manage a sizeable lump sum of money.

Too often, an irrevocable life insurance trust is prepared by an attorney as part of a family estate plan, but little guidance is offered on avoiding taxes.

An existing policy can move out of your parents' estate if transferred to an irrevocable trust and if they retain no incidents of ownership. But your parents have to plan ahead to take tax advantage of this transfer. Policies transferred to a life insurance trust within three years of death will be included -- and taxed -- in the estate, anyway.

An unfunded irrevocable life insurance trust is an estate and income tax planning tool for use in solving a variety of problems. It can be used to:

  • protect and preserve assets;
  • manage assets professionally;
  • avoid probate;
  • provide a source of estate liquidity;
  • create tax exempt wealth; and
  • save taxes in general. It accomplishes the last two points by:
  • lowering or freezing the value of an estate by the grantor divesting himself of ownership of the property; and
  • passing estate taxes by keeping the principal out of the estates of grantor and the grantor's spouse.

So, if you can't get your mom or dad to understand the value of a trust in the form of a life insurance policy that can shelter some of your family's assets from being lost to taxes, explain to them the benefits a policy can have on you and the people they leave behind (your siblings and any grandchildren).

Unlike what the name implies, a life insurance policy isn't necessarily about the life of an individual...but rather the assets accumulated during that person's life.

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