The wealth replacement concept involves a contribution of appreciated property to a charitable remainder trust and then the replacement of the property's value through life insurance proceeds. It is most effective when the donated asset is highly appreciated property earning a low yield on its fair market value. It also helps that the client (donor) is not averse to making a charitable contribution but has a substantial desire to ultimately pass the asset (or its equivalent value) to heirs.
The basic steps to creating a wealth replacement trust are as follows:
- The individual contributes the property to a charitable remainder trust, with the expectation that the property is to be sold and the proceeds re-invested in higher-yield assets.
- Another trust (the wealth replacement trust), with the children as beneficiaries, purchases a life insurance policy on the donor's life in a face amount equal to the value of the property transferred to the charitable remainder trust.
- The tax savings from the charitable gift and the increase in after-tax income (the excess of the annuity from the charitable remainder trust over the income previously realized from the contributed property) are used by the individual to make gifts to the non-charitable trust for its use in making premium payments on the life insurance policy. Up to $11,000 (2004) per donor can be paid annually gift tax-free. Future dividends on the policy can also be used for this purpose.
- At the death of the individual, the insurance proceeds pass to the children free of transfer tax.
The plan has strict technical requirements (e.g., the trust must provide for Crummey powers), and as such, requires expert tax and legal advice.
