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Power your estate plan with a wealth replacement trust

Estate, Gift, & Trust Planning

For many people, charitable giving is an important component of their estate planning. But although sharing your wealth with the organizations you care about can be highly rewarding, you may be hesitant to reduce the amount you’ll leave for children and grandchildren.

One potential solution to this dilemma is to establish a wealth replacement trust (WRT). This type of trust leverages life insurance to replace the value of donated assets, thus allowing you to meet your charitable goals without shrinking your family’s inheritance.

How it works

Typically, this strategy works by pairing a charitable remainder trust (CRT) with a WRT. The CRT is an effective vehicle for making a testamentary gift to charity while generating income and tax savings. Income from a CRT can be used to finance the purchase of life insurance. To do so, the funds are contributed to the WRT, which is an irrevocable life insurance trust (ILIT). The funds are then used to purchase a policy on your life (or the lives of you and your spouse) for the advantage of your beneficiaries.

When you die, or the second of you and your spouse dies, the CRT assets pass to the charity you’ve selected. At the same time, the insurance proceeds are paid to the WRT, which distributes the funds or otherwise uses them on behalf of the trust’s beneficiaries.

CRT benefits

A CRT is an irrevocable trust that provides one or more charitable beneficiaries with a remainder interest. In a typical arrangement, you would contribute stock or other assets to the trust. Then, the trust would pay you (or you and your spouse) an income stream for life — usually a fixed percentage of the trust’s value, recalculated annually. At the end of the trust’s term, the remaining assets would be distributed to the charitable beneficiaries.

CRTs offer several cash flow benefits that can be used to buy life insurance. In addition to receiving periodic income payments, your contribution to the trust generates a charitable income tax deduction equal to the present value of the charitable beneficiaries’ remainder interests. Even greater income tax savings may be available if you contribute appreciated property that would otherwise be subject to capital gains taxes if sold. As a tax-exempt entity, the CRT can sell capital assets tax-free and reinvest the proceeds in income-producing assets (you may be subject to income tax on some or all distributions).

Setting up a WRT

Although it’s possible to replace wealth with a stand-alone life insurance policy, setting up a WRT to hold your policy can offer some important benefits. For one thing, if you own the policy, then the proceeds will be included in your taxable estate. This may reduce the policy’s wealth replacement power. By contrast, if your policy is owned by a properly structured WRT, the death benefit bypasses your estate (although contributions to the trust to cover premium payments are subject to gift tax). Also, using a WRT allows you to place conditions on distributions to your beneficiaries.

Note that it’s possible to transfer an existing life insurance policy to a WRT, but it can be risky. (See “Should you transfer an existing policy?” below.) So unless you’re uninsurable, you probably should make cash gifts to the WRT for the purchase of a new policy.

Case in point

The following hypothetical example illustrates the advantages of this strategy. Susan wishes to donate $2 million to her alma mater. But she’s reluctant to deprive her children of those funds. She contributes $2 million to a CRT for the university’s benefit, which invests the money in conservative income-producing investments.

Susan also establishes a WRT, naming her children as beneficiaries. She makes cash gifts each year to the trust (financed in large part by income from her CRT). The WRT’s trustee uses these gifts to purchase a $2 million insurance policy on Susan’s life. When she dies, the CRT distributes its assets to the university and the insurance company pays the death benefit to the WRT. This money, which replaces the charitable donation, can then be used by the trustee to benefit Susan’s children.

Is it right for you?

Properly designed, the combination of a CRT and WRT may allow you to make substantial charitable donations without reducing the size of your estate. To determine whether this strategy is right for you, you’ll need to determine whether you qualify for the amount of life insurance you need — and what it will cost. You’ll also need to analyze the projected numbers, including costs associated with preparing tax returns and trust documents. Talk to your tax and estate planning advisors about how to proceed.

Should you transfer an existing policy?

It’s possible to transfer an existing life insurance policy to a wealth replacement trust (WRT), but there are some risks involved:

  • Under the “three-year rule,” if you die within three years after the transfer, death benefits will be pulled back into your estate and potentially exposed to estate taxes.
  • To effectively remove a policy you already own from your estate, simply transferring it to a WRT isn’t sufficient.
  • Be careful to relinquish all “incidents of ownership,” such as the power to change beneficiaries or borrow against the policy’s cash value.

To avoid potential mistakes, consider contributing cash to the WRT and have the trustee use the funds to purchase a policy on your life.  

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