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Life Insurance Policies & Trusts
There are several reasons why people create a trust for life insurance policy – the main one being estate planning for minor children. The trust may be created during the settlor’s life time (inter vivos trust) or it may be created after they have passed (testamentary trust). As discussed below, the most common approach is the testamentary trust.
*** a settlor is the person who creates the trust
Life Insurance & Minor Children
Life insurance policies allow a person to name one or more beneficiaries. When the beneficiary is a minor, the proceeds must be paid into court or the Public Guardian or Public Trustee. This will limit the child or guardian’s access to the funds for maintenance and advancement of the minor. There are also fees associated with the management of the funds by the Public Guardian or Public Trustee which are paid from the proceeds in Trust. Lastly, the statutory provision in the Insurance Acts in Canada require that the proceeds are paid to the minor beneficiary as soon as they reach 18 years of age. With proper estate planning, these issues can be resolved by creating trusts for the minor children and appointing a trustee to manage the funds until the child reaches an appropriate age.
Life Insurance – inter vivos Trust
A life insurance policy can be placed into a inter vivos Trust – meaning a person can create a trust for the policy during their lifetime. Often, the policy is settled and the ownership is transferred to the trustee. Although this approach has great benefits in England and the United States, it has very little use in Canada due to Canadian tax law.
Tax consequences of inter vivos Trust for life insurance
There are some tax advantages if the life insurance is owned by a corporation as the premiums are often deductible. However, this exposes the cash value of the policy to creditors of the corporation. Further, there are adverse tax consequences to the named beneficiary if the insured’s estate or spouse is named.
It should also be noted that where there is an investment component, there will be a capital gains tax liability for the individual who created the trust and any income earned by the trust is taxed at the highest marginal rate for individuals.
Where the policy is a simple term life insurance, the inter vivos trust will be tax neutral until the proceeds are paid out after the passing of the insured. This is true unless the trust is a spouse, alter ego or joint partner trust, in which case the insurance would taint the trust for tax purposes. If tainted, the income from the invested proceeds will be taxed at the highest marginal rate for individuals.
A tax benefit may be available if the trust is not tainted and the trustee has the ability to designate beneficiaries (no prior irrevocable designation). In this case, ownership of the trust can be transferred to the beneficiary of the trust without adverse trust tax consequences.
Life insurance – Testamentary Trust
An inter vivos trust is rarely used for life insurance policies. A number of the benefits that are connected to this type of estate planning can be gained by other types of trusts. The most common trust for life insurance policies is the testamentary trust. It is designed to be created by way of trust provisions in the Will or by way of an insurance trust declaration.
Since the tax changes in 2016, the favorable tax benefits are no longer available except for a graduated rate estate (GRE) where the beneficiaries of the trust have low marginal tax rates.
Although there may not be a tax advantage, there are great benefits for minor children, disabled adults, and to safeguard assets from creditors of the beneficiaries. A testamentary trust can also provide for a spouse while protecting capital for children.
How does a life insurance in a testamentary Trust work
The first approach is to name the estate as the beneficiary and allow the funds to enter the estate and distributed in accordance with the terms of the Will. The concern with the approach is that it allows creditors of the estate to take the proceeds and the funds will be probated (administrative estate tax). In the event the deceased does not have a Will, the proceeds will be passed on an intestacy which may result in the proceeds going to someone that was not intended by the deceased.
The more effective approach is to create a customized Insurance Declaration that includes the trust provisions. It allows a person to name a trustee to hold the funds for the benefit of the beneficiaries. This document must be filed with the insurance company to ensure it is enforced.
Where can I find the rules for life insurance policies
The general law relating to life insurance is governed by provincial statute, but they are often very similar – if not identical, based on the Uniform Law Insurance Act. You should review the statue in your province for accuracy.
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