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Leveraging The Dual Protection Credit Shelter Trust

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Life insurance, as an estate liquidity tool, is useful in wealth transfer planning. And although a life insurance policy is typically owned by an irrevocable life insurance trust (ILIT) so that the proceeds are not subject to transfer taxes, the gifts of potentially large life insurance premiums made to the trust may be subject to gift taxes.

Estate and gift taxes are one concern of clients. So, too, is the prospect of spending down wealth during their lifetime to fund long term care expenses. With average annual nursing home costs in 2005 at $66,000 and projected to increase to over $200,000 in 2030, the thought of long term care expenses can be paralyzing.

Nevertheless, many clients are often reluctant to allocate funds to an LTC policy they may never use. Clients often struggle with their desire to transfer wealth efficiently and the need to preserve assets for LTC costs.

One solution is to use a funded credit shelter trust. While keeping assets outside of the estate, the CST can fund death benefit protection and be used for long term care needs during lifetime.

What is a Credit Shelter Trust?

The CST is an important part of most estate plans for married couples. With proper planning, at the death of the first spouse, a specified amount of properly titled assets, known as the applicable exemption amount, can be transferred to the trust free of estate tax.

In 2005 the exemption amount is $1,500,000. The balance of the estate assets, if transferred to the surviving spouse, is not subject to estate tax either since transfers to a spouse qualify for the estate tax unlimited marital deduction. Therefore, using the CST and the unlimited marital deduction, there may be no estate tax due until the death of the surviving spouse.

Because the assets in the CST reside outside of the taxable estate, the CST is a gift tax-free way to fund a life insurance policy on the surviving spouse. By including a long term care rider in the policy for a minimal cost, the leverage that the death benefit provides is flexible enough to transform the policy into a funding source for LTC expenses, outside the taxable estate.

How Does An LTC Rider Work?

Generally, long term care riders accelerate the death benefit during lifetime to cover qualifying LTC expenses of the insured, if needed. The amount of the acceleration is based on the rider contract and its requirements and limitations. In some cases, the amount of the death benefit available will be based on a percentage of the death benefit, usually up to a maximum amount.

The accelerated LTC benefits may be paid in a lump sum or on an installment basis, such as monthly. The payments can also be paid based on actual LTC costs incurred, up to a maximum.

Many of the rider features will be based on the type of underlying life insurance policy. Some life insurance contracts automatically provide an acceleration of the death benefit for specific qualifying long term care needs whenever they arise, or if death is expected to occur within 12 months.

For example, David Goodrich died in January 2005. His estate established a credit shelter trust upon his death and funded it with $1,500,000. The balance of his assets automatically passed to his wife, Janice, estate tax-free using the unlimited marital deduction.

Upon Janice’s death, all the assets in her estate, including those that she inherited from her husband, will be subject to estate tax and then transferred to her two children. Meanwhile, Janice will benefit from no reduction in her estate. She will also be a beneficiary of David’s CST should she require additional funds for her health, maintenance, education and support.

Janice has spoken with her financial advisor and is concerned about her estimated $2,000,000 estate tax liability due upon her death that will diminish the amount her children will receive. Janice is aware that life insurance can provide the liquidity that her children need but is reluctant to pay gift taxes and use current cash flow to fund the required life insurance. Janice is also concerned about the potential for long term care costs but has no interest in paying premiums into a policy she may never use.

Her advisor suggests to Janice that she use the assets in the CST to fund a single premium, guaranteed life insurance policy since she does not need income or distributions from the trust. He also suggests that the policy include a long term care rider that will accelerate the death benefit during her lifetime to cover long term care costs, should she need it.

He assures her that by using a guaranteed, universal life insurance policy, in which no further premiums are due, any LTC benefit payments she does not use will be part of the death proceeds paid upon her death. He also explains that the benefit payments made will be income tax-free.

He uses the following chart to illustrate the mechanics of a $2,000,000 guaranteed, single premium, universal life insurance policy with an LTC rider.

The advisor explains that the trustee of the CST can use $519,631 of the trust assets to purchase a $2,000,000 guaranteed UL policy with a 1% maximum monthly acceleration payment, providing Janice with a maximum payment of $20,000/month until the death benefit is exhausted, potentially for 100 months. He also explains that she will need to satisfy a 100-day waiting period before the payments can begin and that the 100 days can be cumulative and do not need to be consecutive.

He further indicates that the 1% payment will be based on the net death benefit available at the time of the claim. Therefore, if any withdrawals or loans have reduced the death benefit amount, the 1% payment and the number of months of coverage will be based on the reduced death benefit at the time of each payment.

Should Janice require less than the maximum monthly allowable benefit, the remaining death benefit, net of any payments made, will be part of the death proceeds. If Janice requires additional payments in the future, there will be no additional waiting period requirement. And the payments will be based on the net death benefit available when the subsequent claims are made.

The use of a combination life insurance policy results in immediate leverage of $2,000,000, guaranteed death benefit protection and long term care coverage, no premium gifts, and no out of pocket cost to Janice. It’s a dual protection plan. Janice’s heirs will receive the liquidity they need to fund the estate tax liability while Janice is protected from the potentially high costs of long term care.


Unlike an ILIT, a CST is an ideal trust to fund a life insurance policy that includes an LTC rider. If an ILIT is used to fund such a policy, the death benefit proceeds will be subject to estate tax. That is, since the grantor will make contributions to the trust, usually in the form of premium gifts, and may receive benefits from the rider during lifetime, the property of the trust is includible in the estate.

Therefore, an ILIT should not be used to fund a life insurance policy with an LTC rider. Moreover, a CST established at death can own the life insurance policy with the LTC rider on a surviving spouse since the surviving spouse, although a beneficiary of the trust, has not contributed anything to it. The surviving spouse also should not be trustee of the trust, and payments from the trust made to him or her must be discretionary.

Alternatively, a husband and wife may each establish irrevocable trusts during lifetime to house the exemption amount (essentially a living irrevocable CST trust). Each trust could then purchase an insurance policy on the non-grantor spouse. As long as the non-grantor spouse made no contributions (gifts) to the trust, which owns a policy on his or her life, and as long as each trust is drafted differently in substance, the life proceeds should not be subject to estate taxation.

Who Can Benefit From A Dual Protection Policy?

The dual protection approach to wealth transfer planning will be appealing to clients who have an existing CST that has been funded and are concerned about estate and gift taxes, as well as long term care costs. Many times, these clients do not like the idea of paying premiums for a separate LTC policy they may never use. The combination policy also can be used with clients who set up irrevocable trusts during lifetime, providing that each grantor does not make any contributions to the trust.

Lina Storm, CLU, ChFC, is a marketing manager in the Advanced Markets Group at John Hancock Financial Services, Boston, Mass. You can e-mail her at [email protected].

Clients often struggle with their desire to transfer wealth efficiently and the need to preserve assets for LTC costs