How to Transfer Wealth Using Life Insurance

Gift and estate planning are often of primary importance to high-net-worth clients. 

Current law allows each person to transfer up to $11,400,000 to their children or grandchildren without paying any gift or estate tax, but that exemption amount is scheduled to drop in half automatically on January 1, 2026. Depending on the outcome of political elections, the exemption amount could drop further and quicker than that. 

With a current flat tax rate of 40% applied to all assets in excess of the exemption amount, gift and estate tax planning are important not just to clients who currently exceed the exemption amount, but also to clients who are likely to exceed the future exemption amount based on the growth of their assets and potential reduction of the exemption. Fortunately, there are ways to transfer wealth without confronting the exemption. 

Using Life Insurance for Tax-Free Estate Growth

For clients who are interested in maximizing the amount of wealth that can be transferred to the next generation, life insurance is often a perfect asset to use because of the leverage that you get from making a gift of the premiums while having your heirs receive the much larger death benefit. In addition, life insurance death benefits are generally income tax-free, allowing that much larger death benefit to be received without being reduced by income taxes. 

However, in order to avoid having the death benefit itself subjected to income tax, the insured cannot be the owner of the policy. Most often, Schechter Wealth uses an irrevocable life insurance trust as the owner to hold and manage the policy during the insured’s lifetime and also manage and distribute the proceeds following the insured’s death. 

Minimizing Gift Taxes

On the topic of minimizing gift taxes, a properly drafted islet will minimize the use of estate and gift tax exemption by allowing some or all of the contributions to the trust to qualify for the gift tax annual exclusion, under which each person can give up to $15,000 per year to as many people as they’d like before having to use estate and gift tax exemption for anything in excess of that amount. 

However, the tricky thing about making gifts in trust rather than gifts directly to the beneficiaries of that trust and still qualify for the annual exclusion is that the annual exclusion is only available for gifts of a present interest, where the beneficiary or recipient of that gift can benefit immediately rather than at some point in the future. 

Crummy Withdrawal Rights

In order to convert what is ordinarily a future interest into a present interest, the beneficiaries of the trust need to be given a limited withdrawal right, typically a 30-day window within which they can withdraw whatever property was contributed to the trust. Only if they fail to exercise that withdrawal right does the property remain in the trust and get administered under the terms of the trust agreement. 

These limited withdrawal rights are typically referred to as “Crummy withdrawal powers”, so named because Crummy was the somewhat unfortunate last name of the first individual to utilize this method of obtaining the annual exclusion for gifts made in trust. 

How Irrevocable is an Irrevocable Trust?

But how irrevocable is an irrevocable trust? A lot of clients want to know. The term “irrevocable trust” simply means that the terms of the trust agreement itself generally cannot be changed by the creator of the trust, the grantor. 

What a lot of people don’t recognize, though, is that a great deal of flexibility can be built into the terms of the trust agreement itself so that the trust can appropriately respond to changes in the circumstances in the future. The trustee can be given broad discretion over when to distribute assets to the beneficiaries or even how to allocate the assets among multiple beneficiaries. 

For example, the grantor’s spouse can be included as a discretionary beneficiary of the trust so that if the spouse needs the assets, those assets can be available to be distributed. But if the spouse doesn’t need the assets, they can be protected from estate tax. Similarly, the grantor can be given the ability to remove and replace the trustee at some point in the future if the trustee is not operating the trust in the manner that was intended. 

Life Insurance as Leverage

The takeaway from all of this is that high-net-worth clients should consider using life insurance to leverage their gift tax exemptions into the much higher death benefits that can be received from a life insurance policy. They should also consider using an irrevocable life insurance trust to own that policy in order to keep the death benefit outside of their taxable estate.