Wealth Replacement Strategies with Trusts

As we discussed in the legacy planning segment, grandparents and parents usually have multiple goals, and it can take some thought to put together a plan that tries to meet all or most of those goals.

One tool that can add a lot to a plan is the wealth replacement trust. That is a clever name for an irrevocable life insurance trust. Many people believe that with the estate tax being phased out, life insurance has no role in an estate plan. In fact, there are a number of cases when life insurance still is valuable. If the estate tax repeal is not made permanent, life insurance will be attractive to more people in the next few years.

A wealth replacement trust allows the bulk of the estate to be used for the key goals of the estate owner. These goals usually are providing financial independence for the estate owners and making charitable contributions. After those goals are met, there might be little or nothing left for heirs.
The wealth replacement trust is a way to provide for heirs even after meeting those other goals, and the trust often is a cost-efficient way to leave wealth to heirs.

Suppose Max Profits decides he wants to make significant charitable contributions with his estate. He might decide to make the gifts as direct contributions in his will, or he can transfer property to a vehicle such as a charitable remainder trust now. That trust would provide him a lifetime stream of income and give the remaining property to charity.

But Max does not want to leave his children or grandchildren with no inheritance. To meet the other goals and still provide something for his family, Max sets up a wealth replacement trust. He transfers money to the trust. The trustee arranges an insurance policy on Max’s life and uses the money to pay the premiums. The trust is the beneficiary of the policy. Each year, Max can transfer additional money to the trust to pay insurance premiums. The transfers to the trust are gifts to the beneficiaries of the trust, and if the trust is structured properly they qualify for the annual gift tax exclusion. Max can give up to $12,000 per beneficiary gift tax free each year, or Max and his wife jointly can give $24,000 per beneficiary. Or Max can make a large transfer when the trust is created that the trust can use to purchase a single premium insurance policy. If the investment assumptions in the single premium policy are met, no additional premiums will be due.

The trust must be irrevocable, and Max must not be trustee in order for the insurance benefits to be excluded from Max’s estate. If Max is married, the trust can purchase an insurance policy known as a joint life, second-to-die, or survivorship policy. This type of life insurance policy pays benefits only after the second spouse passes away. It is cheaper than a single life policy, providing more benefits to the heirs for the premiums paid.

The insurance benefits will be paid free of both estate and income taxes if the trust is properly structured. The trust also avoids probate.

After the trust receives the policy benefits, some people have the trust pay the benefits to heirs immediately, or immediately after they reach the age of majority. Others want more control. They might have the trust pay only income or a specific amount for a period of years, and pay the principal in stages as the heirs get older. Trusts are very flexible, so the structure is limited largely by the creator’s goals and willingness to pay fees.

The wealth replacement trust also can be useful for someone in a second marriage with children from the first marriage. The trust allows one to provide for both the current spouse and the children without having them share the same assets or have potential conflicts and spending and asset management. The current spouse receives the bulk of the estate, while the children receive the insurance benefits.

The trust also can be used to pay estate taxes on assets so that assets do not have to be sold to pay taxes.

The trust must be established early enough that the life insurance premiums are affordable. In addition, the owner should be aware that the trust is irrevocable. In addition, there must be enough wealth involved to justify the fees involved in setting up and maintaining the trust.

In lieu of a trust, some people set up a partnership to own the policy and have the heirs be the partners. Other people simply make gifts to their children or grandchildren and expect them to use the money to pay insurance premiums. In each case, estate taxes are avoided on life insurance benefits.

Longer life spans and higher investment returns caused life insurance premiums to decline over the last few years. The wealth replacement trust can be an efficient way to meet lifetime goals and still provide significant wealth for heirs.