The Federal Estate Tax has been a moving target since 2001, when the unified credit (the total amount that can pass tax free) was $1 Million for each individual. During the next seven years the unified credit went up to as high as $3.5 Million, then in 2010 there was no estate tax, and in 2011 the estate tax was set to return with a $1 Million unified credit. Congress passed a two-year provision covering 2011 and 2012, and then finally passed a law without a sunset provision covering 2013 and future years. The credit started at $5 Million in 2011 and is set to increase each year with inflation.

As we discuss estate planning with our clients, they often do not realize that the value of life insurance is added to the value of other assets in calculating the Federal Estate Tax. Here's a typical example:

• Alice and Bob are both around 40 years old, married, and have three elementary school age children. If they liquidated their retirement and other investment accounts and sold their home, the total value of their estate is $1 Million. Even if both died in quick succession without Wills or Trusts, they would pay no estate tax based upon their assets, even if the unified credit drops to $1 Million.
• After meeting with their financial planner and life insurance agent, Alice and Bob decide to each purchase $2 Million in life insurance, so that there would be a total of $5 Million for their three children's upbringing, college educations, etc. If Alice and Bob hold that life insurance personally, and the unified credit drops back to $1 Million, then they would only have $1 Million free of estate tax, and approximately half of the $4 Million of life insurance would disappear to taxes.

The solution is to set up Irrevocable Life Insurance Trusts (ILITs) for Bob and Alice. By creating an irrevocable trust, Alice and Bob can ensure that their life insurance policies pass completely tax free to their children or other named beneficiaries, provided that they do not have any ownership or control over their policies in the three years preceding their death. This is best done with new life insurance policies, which become estate tax free immediately, but existing policies can also be transferred into a new ILIT, which become estate tax free after three years. Setting up an ILIT is a great hedge against a lower unified credit or a higher estate tax rate, and ensures that the entire value of the life insurance passes to the beneficiaries.