In many cases, life insurance can also be passed on free from estate tax. In 2010 only, there is no federal estate tax since Congress has temporarily killed it (it is slated to return in 2011). Those who want to avoid it in the future, however, might set up a special life insurance trust with someone else as trustee and give the trust an insurance policy. Since the buyer no longer owns the policy, it isn't included in his estate, yet the proceeds can still be distributed tax-free.

Life insurance also helps those who want to make very large gifts during their lifetime, since such transfers are subject to a gift tax. One of the advantages of a life insurance trust is that it tends to accumulate cash value over a pretty long period of time-the life of the insured. If properly drafted, a life insurance trust can benefit from an annual contribution of $13,000 for each beneficiary without being subject to gift tax. Those annual contributions can grow tax free and eventually become a pretty significant life insurance policy whose proceeds can be passed on without being subject to income taxes, estate taxes or gift taxes. The key is to start young enough.

Even if you do make very large contributions to a life insurance trust-most likely because you are making contributions later in life-the gift tax will often not be too great. First of all, the amount of the gift isn't the amount the policy will ultimately pay out when the insured dies, but rather the amount needed to pay the premium for a particular term, which is much lower.

Second, the gift tax can be reduced by some intricate planning techniques. For example, say instead of paying a gift tax yourself, you loan the money to your life insurance trust to do it for you. In ordinary times, that wouldn't be the best idea, since you wouldn't want the trust to have to make big interest payments, and interest-free loans are strictly limited under the tax code. But with interest rates these days at rock bottom, you could loan money to your trust almost for free. You could also simply loan the insurance trust the money to purchase the policy outright, which would avoid gift tax altogether, but would of course require a much larger and ultimately costlier loan.

Such benefits can make life insurance a crucial part of estate planning. But what about its use in the short term?

Here, the benefits are a bit more debatable. One of the advantages of life insurance is that you can still indirectly access the policy's value even after you have formally given it away to the trust. This is because the trustee can always borrow against the cash value of the policy and then loan you the money. If you don't pay the money back, then the depleted cash value may not be sufficient to pay the full premiums on the policy in later years, which ultimately means a lower payout. On the other hand, individuals setting up life insurance trusts can take a certain level of comfort in knowing that the money is there during their lives if they absolutely need it, which is not the case for many estate planning techniques.

Moreover, if they so choose, investors can accumulate much more cash value than they actually need, because typically insurance companies don't object to the "overfunding" of policies. Some experts consider this a worthwhile investing technique because it avoids income taxes, but others aren't so sure.

"Yes, overfunding a life insurance policy can avoid income taxes," says Jonathan Forster, a shareholder in the Tysons Corner, Va., office of Greenberg Traurig LLP. "But there are other forms of financial planning that are far less cumbersome and don't involve the charges insurance companies impose."

Regardless, it is the rare estate plan that doesn't use a life insurance component. With the estate tax set to return to 55% in 2011, any well-to-do investor would be well served to look into a life insurance policy for the long haul.    

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