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A Way Around Taxes, and Not Just for the Rich and Famous

On his deathbed, Oscar Wilde was offered a sip of champagne. He accepted, saying, "I am dying beyond my means." Make no mistake: death can be an expensive proposition, even if you have the means to go out in style. You can blame estate taxes for that. But one way to ease the cost - to your survivors, at any rate - is with a life insurance trust. Not that most people ever give serious thought to creating one. Promoted by private banks as the last of the great estate-tax shelters, life insurance trusts are often regarded as the exclusive province of the rich and the super-rich. If you think that rules you out, consider this: You could be a prime candidate for a life insurance trust for the simple reason that your estate may be worth a lot more than you think.

Since a life insurance payout isn't subject to income taxes, many people assume it's equally immune to estate taxes. That's not so. For tax purposes, the proceeds are part of your estate, along with your home, car, savings and investments. But with a life insurance trust, proceeds from a policy can be shielded from the Internal Revenue Service.

Many people do not worry much about estate taxes because the I.R.S. lets you leave $625,000 in assets tax free and places no ceiling on what you can leave your spouse.

But even a seemingly modest estate can suddenly swell to $625,000, especially with the stock market spiraling higher. Add the proceeds of a life insurance policy, and plenty of estates would go over the limit. To paraphrase Everett Dirksen, a hundred thousand here, a hundred thousand there and soon you're talking about real money.

Indeed, estate taxes can add up to very real money. Rates begin at 37 percent, spike quickly to 50 percent and level off only after they reach 55 percent.

A life insurance trust can save at least part of your estate from those taxes. Stripped down to its essentials, the trust works like this: You hire a lawyer to create an irrevocable trust. Next, you buy a life insurance policy and make the trust its sole owner. (You can also transfer an existing policy into the trust, but there is a risk: If you die within three years, the proceeds go into your estate and are fully taxed.) You then contribute annually to the trust so that it can pay the premiums. If you follow the rules, the proceeds of your policy will stay out of the clutches of the I.R.S.

Apart from the pleasure of not having to share their bounty with the Government, your heirs will toast you because they can use the untaxed life insurance proceeds to pay whatever estate taxes they do owe. "This is an especially valuable benefit if much of your estate is illiquid," said Howard St.John, a Kingston estate lawyer. "Without sufficient cash, your heirs might have to sell off a home or a family business to pay the estate tax bill."

To be sure, an even simpler way to protect life insurance proceeds from the I.R.S. is to have your beneficiaries own your policy. When you die, the benefits won't be part of your estate and won't be taxed.

Of course, that approach doesn't give you the control or flexibility of a trust. The benefits will be paid directly to your survivors, rather than disbursed by a trustee according to your wishes. Should your beneficiaries decide to use their windfall to back their favorite grunge band, that's their call.

If you decide to set up a life insurance trust, there are some points to keep in mind:

Don't do it yourself. Unless you are a lawyer, attempting to set up your own life insurance trust is about as prudent as removing your own gall bladder. It is "no place for rookies," write Robert A. Esperti and Renno L. Peterson, authors of "Protect Your Estate". "One small mistake and all the tax benefits can be lost."

Remember, irrevocable is as irrevocable does. Make sure you really like the people to whom you are leaving your money, because you won't be able to cut them off if your feelings change. Irrevocable means just that. Once the trust is in place, you generally cannot change the terms or beneficiaries. If you do, the life insurance payout will be fully taxable.

Make the trust, not yourself, the owner of the insurance policy. This is a more complex mandate than you might think. Transferring ownership of your policy means giving it up lock, stock and barrel. Should you retain a single right, like the right to assign or surrender it, all the tax benefits will be lost.

Play the Crummey game. The Federal tax exclusion permits you to make annual tax-free gifts of up to $10,000 to any number of people. The checks you write to your life insurance trust to pay the premiums also count as a tax-free gift. But there is a catch. You must notify your beneficiaries each year that they are legally entitled to dip into the trust and withdraw the payments, even though you would probably break their hands if they tried. These "Crummey notices," named for the payer who wrung this concession out of the I.R.S. in a 1968 court case, may seem like a silly charade. But unless you play along, the payments will be subject to income tax.

Go with term insurance. In a sense, there is a way to "revoke" an irrevocable trust: use term insurance rather than whole life. That way, you can pull the plug on the trust without incurring big losses simply by not paying the premiums. If you default on the premiums on a whole life policy placed in an irrevocable trust, you will forfeit its cash value. How big a policy do you need for a life insurance trust to make sense? Assuming you're over the $1,250,000 hurdle, you should have a policy of at least $250,000. "Otherwise, it may not justify the cost and inconvenience." Fees for creating a trust can typically range from a few hundred dollars to $7,500, depending on the complexity. If the estate includes a family business, that can complicate matters and push up the cost.

In addition to paying a lawyer to set up the trust, you will need a trustee to administer it. This can be a friend or family member, or you can assign the job to a lawyer, an accountant or a bank. The trustee must properly log and account for each contribution, and premiums must be paid from a special checking account used exclusively for financing and maintaining the trust. It is a big job, and the fees can add up to several hundred dollars a year.

In the end, though, it may well be worthwhile. In an era of $300,000 studio apartments and $20,000 mini-vans, it doesn't take a Steve Forbes to amass a $625,000 estate, or to worry about guarding it from taxes.

New York Times

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