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5. How does an insurance trust reduce estate taxes?

The insurance trust owns your insurance policies for you. Since you don’t personally own the insurance or have any incidents of ownership, it will not be included in your estate — so your estate taxes are reduced. (There is a three-year rule for existing policies, which is explained later.)

With the exemption at $5 million, you may not need the estate tax savings right now. But it’s important to understand how this works, because the exemption may be reduced as soon as 2013 and the value of your net estate may increase substantially by the time you die.

Let’s say you are married, with a combined net estate of $3 million, $1 million of which is life insurance, and both you and your spouse die when the estate tax exemption is $1 million and the top tax rate is 55%. A tax planning provision in a living trust or a will could protect up to $2 million from estate taxes. But your estates would have to pay $435,000 in estate taxes on the additional $1 million. With an insurance trust, the $1 million in insurance would not be in your estate. That would save your family $435,000 in estate taxes.

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