What to Do if Your Life Insurance Premium is Greater Than the Gift Tax Exclusion

The Problem

When someone owns a large estate, they will usually seek what is called an irrevocable life insurance trust (ILIT). FindLaw explains:

“Like most trusts, [an ILIT] is simply a holding device. It owns your life insurance policy for you, removing it from your estate. As its name suggests, the Irrevocable Life Insurance Trust is irrevocable. That means once you've created it and placed an insurance policy inside it, you can't take the policy back in your own name.”

The article continues:

“But you can closely control many other aspects of the ILIT. You can dictate who your initial beneficiaries will be and define the terms under which they will receive benefits. You can choose the Trustee (or Trustees) who will manage your ILIT.

An ILIT provides you, your loved ones, and your estate with considerable advantages. But these benefits can only be achieved if the ILIT is designed properly and specific guidelines are followed carefully.”

Now, what if the premium is $100k? That would trigger a gift tax for the remaining $32k of premium due. There is an option to cut into the lifetime exclusion; which is expected to revert to about $6 million in 2026, but most people would prefer not to eat away at their lifetime exclusion.

So, what can you do to stay within the annual exclusion?

Solution 1: Third Party Financing

A simple solution is for the Trust to borrow money from a third party, such as a bank, to fund your life insurance. Many people like this option because they don’t use any of their exclusion at all, and the entire premium is borrowed. You can gift to the trust the interest of the loan—which will likely be relatively low—each year so that the trust can pay the interest on the debt.

The growing loan eventually has to be repaid, which you may choose to accomplish via the death benefit in the life insurance policy. Whatever is owed to the bank when you die is taken out of the payout, and your family receives the remaining funds.

The policy is essentially collateral for the loan. Be aware that premium financing does have some risks, namely interest rate volatility, loan renewal, and poor policy performance. Chamberlain Financial:

“Because most premium financing contracts have terms less than the life of the policy, they have to be renewed periodically, requiring refinancing.”

“If the policy’s cash surrender value under-performs, the loan balance could exceed the value of the collateral, in which case the insured would be forced to provide more collateral to avoid default. Likewise, if the death benefit fails to grow, the policy could provide less coverage than expected when the loan is finally satisfied. In the worst cases, the insured’s estate would have to repay the loan if the death benefit could not.”

Solution 2: Split Dollar Financing

Because of the risks in premium financing, we often recommend a strategy called split dollar life insurance. 360 Degrees of Financial Literacy explains split dollar life insurance as follows:

“Split dollar life insurance is an arrangement between an employer and an employee to share the costs and benefits of a life insurance policy. Specifically, the parties join together to purchase an insurance policy on the life of the employee and agree, in writing, to split the cost of the insurance premiums, as well as the policy's death proceeds, cash value, and other benefits. The actual life insurance policy used can be whole life, universal life, second-to-die (survivorship), or any other cash value policy.”

In a private split dollar plan, money is gifted to the ILIT to pay the life insurance premiums. The trust then owes back either the cumulative premiums paid or the cash value of the life insurance—whichever is greater—upon the policyholders’ deaths.

The value of the death benefit becomes key in this type of arrangement, as does proper reporting to ensure the gift to the trust is made and tracked. We won’t go further into the weeds for the purpose of this article. If you would like to know more about split dollar life insurance, call JRC at 855-247-9555.

Exit Strategies

The drawback of split dollar plans is that each year you age, the imputed cost of insurance rises. The drawback of premium financing is that the loan grows as the premium is borrowed each year.

If you live long enough, it can easily exceed the death benefit in the policy. Therefore, it’s important to have a way that the trust can pay back the money owed under the premium financing or dollar arrangement.

The three most common ways to accomplish this is are with a Grantor Retained Annuity Trust (GRAT), an Intentionally Defective Irrevocable Trust (IDIT), and a Charitable Lead Trust.

The common concept with all three is for the trust to obtain a highly appreciating asset without incurring a gift tax. The asset can be used down the road to payback the moneys owed.

We further explained each strategy below:

• GRAT

The idea is to have the value of the income stream that you’re getting back equal the amount that you’re putting into the trust so that there is no gift at all. The annuity is for a fixed period, after which the asset is received by the trust and there are no more annuity payments to the individual, assuming they are still alive.

If the individual does not survive the annuity term, a portion of the value goes back into the estate. Attorneys often turn to two-year GRATS as a means of avoiding the ups and downs that can happen over a longer term.

• IDIT

• Charitable Lead Trust

A charitable lead trust is somewhat self-explanatory in that it pays a charity for a set period of time.

“The whole idea of a charitable lead trust is to reduce taxes upon the estate left by the deceased. This is done by donating to charities from the estate until all taxes are reduced. Once this is accomplished, the estate is then transferred to the beneficiaries, who typically will face lower taxes.

Many different organizations offer information regarding the set-up of these types of trusts. Examples are universities, colleges, and non-profit societies.”

Work with an Expert

If you are attempting to use any of the above strategies, it’s important to let an experienced and independent life insurance agent and attorney help you navigate the nuances. JRC specializes in customized life insurance policies from top insurers, working with clients to identify and meet their needs.

Estate planning with life insurance is a job we take seriously because we know we are helping families solidify their financial future. Learn more here, or call us today toll-free at 855-247-9555.