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Planning Your Estate
Part 4 -- Life Insurance, Annuities, and Trusts

Life Insurance

For most families, life insurance is an important tool in an estate plan. Its uses include:

Increasing an estate -- This is done by adding insurance protection. Proceeds can be used to support surviving family members and to continue the decedent's family business.

Paying expenses and debts -- A variety of items -- funeral expenses, debts (including mortgages against land, machinery, and livestock), and administration costs must be paid when an individual dies. Life insurance provides immediate cash for the estate to meet these liabilities.

Paying estate taxes to avoid liquidating a business -- Federal and Mississippi estate taxes are due 9 months after date of death, unless the executor is granted permission to pay the estate taxes in installments.

Providing management -- If it is not advisable for beneficiaries to administer insurance proceeds, as in the case of minors or an incompetent spouse, the funds may be put into a trust.

Providing a way to treat all heirs equally -- Mr. Doe has a son and daughter, but only the son wants to stay on the family farm. Through life insurance, Mr. Doe can acquire assets that would enable him to leave his son the farm and his daughter an equal (or nearly equal) amount of property in the form of life insurance proceeds. Alternatively, the son can buy life insurance on his father's life so he can buy out his sister's proportional interest in the family farm after their father's death.

Is Life Insurance Subject to Estate Taxes?

Many people are not aware of the taxable status of life insurance proceeds. They assume the proceeds are automatically tax-free in all cases.

Life insurance is subject to federal estate taxes if the policy holder has "incidents of ownership" in the policies (such as the right to change beneficiaries, to borrow cash value, to select dividend options, to change premium payment schedules) or if the proceeds are payable to the estate. Any unpaid dividends also are taxable in the estate.

In Mississippi, life insurance proceeds, if the policies were owned by the decedent and to the extent their value exceeds $20,000, are includable in determining state estate taxes.

Change of Ownership

To make sure beneficiaries fully benefit from each dollar of life insurance, the insured may find it advisable to establish ownership in someone else's name (spouse or children for example) of all or some of his insurance. Then if he does not retain "incidents of ownership," policy proceeds will not be included in his gross estate.

Example: Murland is the owner of a $50,000 insurance policy on her husband Frank. Upon his death, the $50,000 will not be included in his estate since his wife is owner of the policy. If the estate has been named as beneficiary and the policy transferred within three years of Frank's death, then the proceeds would be included in his estate.

The transfer of a life insurance policy is considered a gift if a policy is transferred to a spouse after the initial purchase. The value of the gift is the replacement cost of the policy at the time of the transfer. Any premium payments made by one spouse on a policy owned by the other spouse also are considered a gift for taxation purposes.

If your total estate, including life insurance proceeds, is less than the amount subject to federal estate taxes ($600,000 in 1987 and thereafter), form of ownership may not be of concern to you. As soon as your estate reaches this amount, you may want to review the situation with your insurance representative to evaluate the tax consequences.

Life Insurance for Me?

There are many insurance companies, agents, and variations among term and permanent policies. Shop around for the best policy at the least cost for your situation.

Before purchasing insurance or changing policies, ask these questions:

Do I need life insurance?
If I need insurance for debts, mortgages, taxes, or family income, how much can I afford to pay for annual premiums?
What kind of insurance should I buy?
From what company?
Once I purchase the insurance, should I ever consider increasing or decreasing the amount I own?
When should I give away my insurance policies to save taxes?

Many of these questions can be answered by a qualified and experienced insurance agent.

Annuities

An annuity is another useful tool to help plan your estate if the annuity is properly designed and implemented. Costs vary, depending on the type of annuity and on the age of the person making the purchase.

Here's how it works: An owner exchanges property or cash for an annuity income based on the fair market value of the property transferred and his projected life expectancy, as calculated according to actuary tables.

There are two types of annuities -- commercial and private.

Commercial Annuity

A commercial annuity is typically issued by an insurance company for cash. The annuitant pays a sum of money to the company (the insurer) which promises to make periodic payments for the remainder of the annuitant's life. An annuitant can choose to have the annuity continue for his survivors. For example: the approximate cost of a straight-life annuity on a man aged 65, which returns $100 per month in income for the man's life, is $13,000.

Private Annuity

A private annuity differs from a commercial one in two respects: Usually, property other than cash (for example, real estate) is used to acquire the annuity, and the promise to make the payments is made by an individual (often a relative) rather than an insurance company. A private annuity usually ceases upon death.

A private annuity can be used if parents want to transfer a farm to a child in exchange for a guaranteed income for life. However, no mortgage or other security (except life insurance in event of death) may be given to the parents to guarantee payment of the annual amounts required to be made. This could be considered a serious drawback by some parents. In addition, there may be serious income tax consequences to the child should he sell the real property acquired by the annuity.

Annuities for Me?

Annuities can be effective as an estate-planning tool if proper guidance and advice are secured in setting up the annuity. Consult a life insurance agent and tax accountant for further information and an attorney for legal implications.

Trusts

A trust is a legal arrangement by which an individual transfers assets to a trustee who manages the assets for the benefit of those designated in the trust instrument.

There are two basic kinds of trusts -- testamentary and living (inter vivos).

Any type of asset -- cash, stocks, bonds, life insurance, and real estate -- can be put into a trust.

A trust can be created by a trustor for the benefit of himself, friends, family members, college, hospital, library, charitable organizations, or any other type of institution.

The person providing assets for the trust is the trustor or grantor.

The trustee manages the assets according to the directions in the trust agreement. The trustee can be an individual (even the person creating the trust), several individuals, or corporate entity (bank or trust company), or any combination of these.

A trust agreement is a document containing the instructions to the trustee, stating, for example, who is to receive income from the trust and when and how it is to be distributed. When the trust terminates, the trustor's instructions control the distribution of the assets in the trust and the transfer of those assets to the "remainder beneficiaries."

Testamentary Trust

A testamentary trust is created by a will and does not take effect until the will is declared valid by the court. Such a trust places assets with a trustee who has good management and investment skills and who will use them for the beneficiaries.

Parents with minor children could create a trust to provide a way for their assets to be managed until their children are old enough to do it themselves.

A surviving spouse may not have the ability to manage the deceased's estate. A trust may provide a desirable method of arranging for the distribution of the assets and management for the spouse.

Another form of the testamentary is the A-B trust. It provides a way to reduce taxes on the estates of married couples. The marital deduction, or A trust, is set up by transferring the amount of the desired estate marital deduction into the A trust.

The A trust passes to the surviving spouse, estate-tax-free. The surviving spouse has a general power of appointment and can do anything with this half of the property. The A trust is taxed only in the surviving spouse's estate upon death.

The nonmarital (or B trust) contains the portion of the estate not going into the A trust. The B trust is taxed in the estate of the first spouse to die. The surviving spouse has a limited power of appointment but can draw up to $5,000 or 5 percent annually, can draw for living expenses, and can give the trust principal to anyone except him- or herself. A properly formed B trust is not taxed in the surviving spouse's estate.

Living Trust

A living trust is created by a person during his lifetime to operate for his own benefit or for the benefit of another person. Example: A living trust could be created by a person who is too busy to worry about investment responsibilities. He may want an expert's help and assistance in the management of investments. He could have the income from the trust himself or have it distributed to a relative.

There are two kinds of living trusts, revocable and irrevocable.

A revocable living trust is as its name implies--one created during the testator's life and can be changed and terminated at any time by the method described by the trustor in the trust agreement. There is no gift tax payable upon the creation of a revocable trust, because a trust is formed that can be changed at any time.

In a revocable trust, the following rights are reserved: to amend the trust, to change the beneficiaries, to change the trustee, to change the date of termination, or to change the entire trust by revoking it and asking for the return of property. Any benefit paid to beneficiaries is a gift and would be a future interest.

An irrevocable trust cannot be canceled. The trustor gives up forever the assets assigned to the trust. Gift taxes, if any, are due when the trust is created. Generally, no estate tax accumulates on the trust property when the trustor dies if he lives 3 years after creating the trust. If the trustor retains income for life on the trust, no estate tax savings are realized.

An irrevocable trust can be used when an individual wants to make a gift so that persons will receive income before the donor's death, but not the property until after his death.

With creation of an irrevocable trust, a new taxpayer (the trust) is created and that new taxpayer can be authorized to distribute income to other beneficiaries (children, grandchildren, parents, dependent relatives, and so forth). By dividing assets between two taxable entities, the taxable income of each is reduced since each is in a lower tax bracket.

Powers of Trustee

Broad administrative and investment powers usually are given the trustee. These powers are important, because investment and business conditions change and the trustee should be able to adapt to the pressures created by a changing economy. The needs of beneficiaries may also change, and the trustee should be free to meet the needs (within limitations) of the assets in the trust.

Examples of the more common powers that can be written into testamentary trusts to give them flexibility include:

Power to buy and sell. The trustee may be authorized to buy and sell or reinvest the assets when it is beneficial to the trust.
Power to apply income. In case of unusual circumstances, the trustee may be given the discretion to apply the income for the use of the beneficiary. This authorization permits payment, when necessary, directly to creditors, including hospitals and doctors. This is especially important when the beneficiary is a person of advanced years or is physically or mentally incapacitated.
Power to use principal. The trustee also may be authorized to draw funds from the trust principal if income from trust is insufficient to meet the beneficiary's needs. Many trust agreements limit use of the principal to special circumstances -- e.g., illness, education of children, and hardship.
Power to "sprinkle" income unequally. This power gives the trustee the authority to make unequal payments among several beneficiaries, depending upon their individual needs. For example, the cost of a college education for one child could be paid directly from the trust instead of being paid by the surviving spouse from income after taxes. This procedure could reduce the total amount of taxes paid and increase the surviving spouse's spendable income.
Power to accumulate income. Whenever some or all of the income from a trust is accumulated, it may be taxed to the trust as a separate taxpayer. This means there are two taxpayers instead of one. Because the trust is a new taxpayer and may be in a lower tax bracket than the beneficiary, there is the opportunity for income splitting with possible substantial tax savings.

Pointers for Trust Makers

The decision to form a trust has consequences for the trust maker and beneficiaries. Explore these consequences with experienced professional counsel to insure the proposed arrangement is not in violation of existing tax laws. Be cautious of proposals (such as the "pure equity trust") that "guarantee" freedom from payment of all taxes in all circumstances.

If tax minimization is a major objective, ask about the tax consequences of the trust--at the time it is created, while it is in operation, and when it terminates--before you create a trust.

The trust agreements or the trust documents provide the opportunity for complete specifications of trustee duties, trust operations, distribution of income, and distribution of principal. All of these duties must be carried out by the trustee. The powers of the trustee may be made as liberal or as specific as the individual chooses, but the more restriction placed upon a trustee, the more difficult a trust may be to administer, and you may be unable to obtain a qualified trustee.

Many people include in the trust document the right of the beneficiaries to change trustees if for any reason the trust operation is not going smoothly; for example, personality conflicts or the trustee's inattention to the responsibilities of the trust.

Trustees are entitled to compensation for their services in the same way executors and attorneys are entitled to compensation for settling an estate. Inquire about the costs of administering the trust, the trustee fees, and the other costs imposed before creating the trust. The fees involved vary, depending on the size of the assets of the trust. Fees are based on a percentage of the market value of trust assets.

Trusts For Me?

When you have considered the needs of you and your beneficiaries -- and discussed with professionals the tax consequences and the costs of trustee operation and management -- you will be prepared to make decisions about advantages and disadvantages of trusts for you and your family.

If you decide on a trust, select the best legal and financial advice available to create the trust documents and put them into effect.

References

Information in this series is adapted from Estate Planning for Every Montanan by Marsha A. Goetting, Montana Cooperative Extension Service.

Lynn, Robert J. Introduction to Estate Planning. St. Paul, Minn., West Publishing Co., 1981.

Martin, Robert J. "Estate Planning: An Investment in Your Family's Future," Publication 1373, Cooperative Extension Service, Mississippi State University, 1990.

Milner, Dorothy Leggett. "An Introduction to Estate Planning." Research paper, Mississippi State University, 1978.

Mississippi Code 1972 (Annotated), Vol. 20, Title 91, Sections 91-1-1 through 91-7-1.

State of Mississippi Estate Tax Law, Mississippi State Tax Commission, 1978.

Quiz

Section 1

Joe has a term policy with a face value of $50,000. He has retained the right to change beneficiaries. Would the $50,000 be included in his estate? yes no
Mary is the owner of a $50,000 term life insurance policy on her husband Ralph's life. Her husband dies. Is the $50,000 included in his estate if not transferred within 3 years and Ralph's estate is not the beneficiary? yes no
Section 2

Use the terms below to answer questions 3-12. They may be used more than once.
1. a. Testamentary
  b. Living (inter vivos) revocable
  c. Revocable
  d. Irrevocable
  e. Annuity
  f. Marital deduction
  g. Trust agreement
  h. Remainder beneficiaries
  i. Commercial
A ______ trust is created by a will and does not take effect until the person dies.
A ______ trust is created by a person to operate during his lifetime.
A ______ trust allows the trustor to change the beneficiaries, amend the trust, change the trustee, etc.
A ______ trust cannot be changed or canceled, but it can be amended.
For a(n) ______, an owner exchanges property or cash for an income based on the fair market value of property and his projected life expectancy, according to actuary tables.
The assets in a ______ trust will be taxed in your estate for federal and Mississippi estate tax purposes.
A ______ annuity is typically issued by an insurance company for cash.
The ______ trust is often used by married couples to save federal estate taxes.
______ is a written document containing instructions to a trustee stating, for example, who is to receive income from trust and how income is to be distributed.
When a trust terminates, the trustor's instructions control the distribution of the property in the trust and transfers that property to the ______.

Answers to the quiz

This publication is not designed as a substitute for legal advice. Rather, it is designed to help families become better acquainted with some of the devices used in planning an estate and to create an awareness of the need for such planning. Future changes in laws cannot be predicted, and statements in this publication are based solely on the laws in force on the date of printing.

By Beverly R. Howell, Ph.D., Family Economics and Management Specialist

Mississippi State University does not discriminate on the basis of race, color, religion, national origin, sex, age, disability, or veteran status.

Publication 1741
Extension Service of Mississippi State University, cooperating with U.S. Department of Agriculture. Published in furtherance of Acts of Congress, May 8 and June 30, 1914. Ronald A. Brown, Director

Copyright by Mississippi State University. All rights reserved.

This document may be copied and distributed for nonprofit educational purposes provided that credit is given to the Mississippi State University Extension Service.

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Planning Your Estate Part 4 -- Life Insurance, Annuities, and Trusts