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New estate tax rules may affect life insurance decisions

It's tough to make a smart move when you don't know the rules of the game, but that's been the position for wealthy people trying to do long-term financial planning, given the uncertainty surrounding estate tax law.

Fortunately, the way forward is clearer, thanks to provisions in the American Taxpayer Relief Act of 2012, the legislation that steered the nation away from the fiscal cliff.

"There's now permanence in the estate tax law that hadn't existed in over a decade," says Chris Morton, vice president of legislative affairs for the Association for Advanced Life Underwriting. He calls it a big win for both consumers and financial advisers.

Estate tax and life insuranceThe numbers

The new law sets the top estate tax rate at 40 percent and maintains the amount you can give tax-free to others during life or at death at roughly $5 million for individuals and $10 million for couples. The tax-free amounts are indexed for inflation. The 2013 levels are $5.25 million for individuals and $10.5 million for couples.

Had Congress done nothing, the top estate tax rate, which had been 35 percent, would have gone up to 55 percent, and the tax-free amounts that people can give or leave behind would have fallen to $1 million for individuals and $2 million for couples.

Estate tax levels and tax-free exclusion amounts are important to consider when deciding the type and amount of life insurance to buy.

If your estate is large enough to trigger taxes, then permanent life insurance is a wise choice. Your heirs can use the life insurance death benefit, which is tax-free, to pay the estate taxes. Without the life insurance money, heirs often have to sell off parts of the estate to pay Uncle Sam. That can be a heartbreaking position for loved ones trying to preserve a family business or property that's been in the family for generations.

Taxes during life and at death

The exclusion amount for gift and estate taxes -- the amount you can give or leave behind to someone tax-free -- is one lifetime total. Tax experts call this "unified." Say, for instance, you want to give your son $1 million during your lifetime. You can do so without triggering a gift tax, but the tax-free amount you can leave him at death is reduced by $1 million.

Meanwhile, relatively small gifts don't count toward the exclusion. You can give up to $14,000 a year to someone without it counting against the lifetime exclusion amount.

If you're married

The law maintains an unlimited deduction for estate and gift taxes for spouses. That means a widow or widower doesn't have to pay estate taxes on anything inherited from a spouse. But the tax burden passes onto the heirs after the second spouse dies.

Meanwhile, the exclusion amount -- the amount you can give tax free -- is portable. That means it passes from one spouse to another when one of them dies. Say, for instance, a husband hasn't used any of his gift and estate tax exclusion amount. When he dies, his exclusion -- which this year would total $5.25 million -- transfers to the wife. She then has her own exclusion of $5.25 million, plus his.

Under the new law, it is no longer necessary to set up a credit shelter trust, or by-pass trust, for the exclusion to transfer to the spouse, Morton says.

However, an estate tax form must be filed at the death of the first spouse.

Permanent? Wait and see

Some finance experts call the recent estate tax law fixes "permanent," but that should come with a caveat, says Charles Matt, a financial adviser with Sapient Financial Group in San Antonio, Texas. A "legacy tax," a precursor of today's estate tax, was made law in 1898 to help pay for the Spanish-American War. It was repealed after the war ended in 1902, but the concept was reborn 14 years later when the federal estate tax was enacted.

"Every few years estate tax law seems to be something of a political football," Matt observes.

Keep that in mind as you consider how to protect an estate for heirs.

"And don't forget to account for the growth of an estate over time," he adds. "It may not look like you need life insurance to protect an estate today, but people who are financially successfully tend to continue to be financially successful."

More from Barbara Marquand here

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