Common Mistakes in Estate Planning with Permanent Life Insurance

Whenever we have a new client come through our doors, we like to take a look at what policies and irrevocable life insurance trusts (ILIT) they already have in place. Often, we see a pattern when it comes to the errors made in these clients’ estate plans, and it can take a bit of work to fix them. Some of the most common mistakes in estate planning with permanent life insurance can be avoided if you understand why these errors cause so many problems.

When Incidents of Ownership Invalidate Your Trust

Most people using permanent life insurance for estate planning run into problems with their trusts due to potential incidents of ownership. Incidents of ownership don’t just include you being the owner of a policy. They also cover any rights that you maintain to modify, use, or benefit from the policy. If you are found to have incidents of ownership, then the trust and their contents may be considered part of your estate.

To avoid this, the most obvious part is that you cannot have any ownership interest in the policy or in the trust. That means you can’t be a trustee or a co-trustee, and you can’t use the policy or funds from the policy directly. Consider the case in which the life insurance policy is owned by a trust but has a long-term disability rider. If you become disabled and receive funds directly from the rider — either by the trust paying you or paying for your care — that would be an incident of ownership because you’re benefitting from the policy.

Spousal control would also mean an incident of ownership. This means your spouse could not be a trustee — though some choose to name their spouse as a co-trustee. Keep in mind this only works in the case of a single life policy, and not a joint life policy in which both you and your spouses are considered the insured.

Finally, naming the wrong beneficiaries in the trust is a problem we sometimes run into. The trust should be there to benefit your heirs. If you simply make your estate the beneficiary, then that ownership interest gets transferred right back to you after your death, making the trust invalid.

To set up an effective trust, the trust must be irrevocable and any insureds on the policy cannot be trustees or co-trustees. Once you have the trust in place, it will need to be properly maintained to ensure it stays valid.

How Ineffective Crummey Notifications Can Cause Trust Problems

A Crummey notification is an important part of maintaining a trust. To create an effective trust, your heirs must have the option of having the immediate benefit of using the funds that you put in that trust. Whether or not they exercise that right doesn’t matter. It’s that they have the option to do so.

Here’s how it works. You set up a trust and, using your annual gift tax exclusion, you make a donation to the trust to benefit a specific person. But the IRS doesn’t recognize gifts given for future interest as a qualified gift. To make that gift qualified for the annual gift tax exclusion, you need to allow the beneficiary an opportunity to do what he or she wants with the money.

So the trustee needs to send out something called a Crummey notification to your beneficiary, giving him or her a specific period of time to use the money gifted. If the period lapses without the beneficiary exercising his or her rights, the trust is then permitted to use the money to purchase a life insurance policy on your life to benefit the beneficiary.

An effective Crummey notice is one that gives the beneficiary enough time to exercise his or her rights to remove the money. If the beneficiary does choose to withdraw the money, he or she has to be given the immediate right to withdraw up to the full amount gifted. Finally, there can be no agreement — either express or implied — that states that the beneficiary will not exercise those powers.

Sending these notices out on time and giving the beneficiary proper notice to exercise those rights, while also allowing enough time to cover a premium payment, all requires careful management. This means that the trust will need to be managed by someone who understands Crummey powers to fund the trust with annual gift tax exclusions.

While ineffective Crummey notices and incidents of ownership in trusts are common problems we see, there is another one which is even more common. That is not having adequate coverage with the policies in the trust.

Calculating the Right Amount of Coverage

The life insurance needs for someone planning for estate taxes are significantly different than the life insurance needs for someone just looking to provide for heirs in the event of death. Having the right amount of insurance can be especially difficult to manage for someone with a lot of property or business interest that can’t be liquidated.

Say you have an estate made up solely of property, and that property is worth more than the $11.2 million federal exemption amount. You do the math and realize that do to the appreciation of your real estate portfolio, you’ll have substantial estate tax after your death. You estimate that at a 40% tax rate, your estate will be hit with a $3 million tax bill. So you create a trust, which purchases $3 million worth of life insurance to cover the taxes on that property, so your family won’t have to sell it. Then you die 10 years later and, when you die, that property is worth 50% more. The $3 million you have in life insurance won’t give your heirs enough money to pay that tax bill. You might need to adjust the coverage.

Having inadequate coverage is one of the most common problems we run into. That’s why we recommend that our clients regularly evaluate their estates to ensure there’s enough in trust to cover those tax bills as their estate values increase.

All of these issues can make a trust ineffective, which is why whenever we meet with a new client for estate planning, we do a full policy review to find those issues and correct them. Contact a Howard Kaye advisor by calling 800-DIE-RICH so you can review your estate plan and make sure it’s covering your estate for the long run.

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