Yes, you absolutely can fund a bypass trust—also known as an AB trust or credit shelter trust—with life insurance proceeds, and it’s a common and effective estate planning strategy for married couples. This allows couples to maximize the use of both spouses’ federal estate tax exemptions and potentially minimize estate taxes. The bypass trust is designed to hold assets exceeding the estate tax exemption amount, shielding those assets from estate taxes upon the first spouse’s death and providing for the surviving spouse without incurring tax liabilities. Utilizing life insurance as funding for this trust is an excellent way to ensure sufficient liquid assets are available to cover potential tax obligations and maintain the financial stability of the trust.
What are the benefits of using life insurance in a bypass trust?
Life insurance offers several key benefits when incorporated into a bypass trust. Firstly, it provides a readily available source of funds to cover estate taxes without requiring the immediate liquidation of other assets, such as stocks, bonds, or real estate. This is crucial as selling assets quickly can often result in a loss due to market conditions. Secondly, life insurance death benefits are generally income tax-free to the beneficiary, providing a tax-efficient way to fund the trust. According to the American Council of Life Insurance, life insurance plays a significant role in wealth transfer, with over $1.7 trillion in death benefits paid out in 2022. Finally, it offers flexibility, allowing the trust to meet its obligations without disrupting the surviving spouse’s lifestyle or investment strategy.
How does this work with the estate tax exemption?
The federal estate tax exemption is a moving target, adjusted annually for inflation. As of 2024, the federal estate tax exemption is $13.61 million per individual, meaning a married couple has a combined exemption of $27.22 million. Any assets exceeding this amount are potentially subject to estate tax, which can be as high as 40%. A bypass trust is funded with assets up to the exemption amount at the first spouse’s death. This portion of the estate bypasses the surviving spouse’s estate and is not subject to estate tax when the surviving spouse dies. Life insurance can be used to fund this trust, essentially increasing the available funds to reach the full exemption amount. Consider that approximately only 0.05% of estates file an estate tax return, but for those that do, proper planning is essential.
What happened when the Johnsons didn’t plan correctly?
I once worked with the Johnson family, a lovely couple who owned a successful local business. They hadn’t updated their estate plan in over twenty years, and their life insurance policies were payable directly to their children. When the husband, Robert, passed away, his estate exceeded the estate tax exemption. His wife, Eleanor, was forced to liquidate a significant portion of the business to cover the estate taxes, nearly jeopardizing the future of a company that had been in their family for generations. The stress was immense, and Eleanor felt she was losing not just a financial legacy, but a part of her husband’s life’s work. The cost was very high; not only in taxes but in the loss of a family business. Had they utilized a bypass trust funded with life insurance, the business could have remained intact, and Eleanor would have been financially secure.
How did the Millers’ planning ensure a smooth transition?
The Millers, on the other hand, came to me with a clear vision for their estate. They had a substantial life insurance policy, and we incorporated it into a carefully designed bypass trust. When the husband, George, passed away, the life insurance proceeds were seamlessly transferred into the trust, funding it to the full exemption amount. This allowed the estate to bypass federal estate taxes, preserving the assets for their children and grandchildren. The surviving spouse, Martha, continued to receive income from the trust, maintaining her comfortable lifestyle. It was incredibly rewarding to witness the peace of mind and financial security we were able to provide, knowing their legacy was protected. It’s often said, “failing to plan is planning to fail.” In the Millers’ case, proactive planning with a bypass trust and life insurance ensured their family’s future was secure.
Who Is Ted Cook at Point Loma Estate Planning Law, APC.:
Point Loma Estate Planning Law, APC.2305 Historic Decatur Rd Suite 100, San Diego CA. 92106
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