How to use insurance trusts
An insurance trust is a useful tool in estate planning because it gives you control over the timing and use of insurance proceeds. While these trusts are usually put in place for the benefit of children, they can be effective in other situations as well.
Insurance proceeds from such a trust do not form part of the deceased’s estate. This may reduce probate fees and creditors’ claims.
When the beneficiary is a minor, they’re not considered legally competent to provide a discharge to the insurer for the proceeds of an insurance policy. So the insurer has three options for disbursing the death benefit. They must either:
- Pay the funds to a named trustee (the most common option)
- Pay the funds into court
- Pay the funds to a public trustee
Using a trustee
The first option is the most commonly used for the following reasons:
1. It assures the policy owner that the funds will be received for the benefit of the minor child.
2. It provides flexibility as to how the child will benefit from the proceeds, and the conditions under which the child may eventually receive the proceeds of the policy/P>
3. It prevents misuse of the funds by an irresponsible beneficiary
A valid insurance trust is created simply through the beneficiary designation in the policy. This says the proceeds are to be paid to the named trustee, with the additional words “in trust for (a named beneficiary)”.
In this situation, the absence of any other trust documentation is likely to cause some minor problems. The trust will be limited to the terms set out in provincial legislation, and other applicable laws.
These limitations may hinder the best efforts of a trustee, and may not be in keeping with the wishes of the insured.
Next page: Potential problems
The potential problems of relying on the beneficiary designation alone include:
- The trustee will be unable to encroach on the capital of the trust regardless of the minor’s needs.
- The minor child is entitled to receive the insurance funds upon reaching the age of majority.
- The trustee may not have the discretion to ensure that the least tax is paid on the earnings of the trust.
- The trustee will be limited by law in the types of investments that can be made.
In creating an insurance trust, you must ensure that all legal documentation supports the same end. So the will, the beneficiary designation in the insurance policy, and other trust documentation (if there is any) must all support the same result.
Here is a simple but damaging example of why:
Assume an insurance trust has been set up in your will, or in separate trust documentation. You accidentally make a different beneficiary designation using the beneficiary designation in the policy. Which one will prevail?
Under provincial legislation, a later valid beneficiary designation will automatically revoke all prior designations.
If a policyholder made an earlier beneficiary declaration under his will, then the declaration within the will would no longer have effect. Thus the intended insurance trust would not be created.
An insurance trust will generally be a testamentary trust, and taxed at graduated rates. Taxes must be paid on all income earned within the trust that was not distributed to the beneficiary(ies).
At one time it was possible to flow income out to a beneficiary without the income actually being payable to them. This was effected by what was known as the “preferred beneficiary election”.
This is now not generally available. It’s restricted to cases where the beneficiary is mentally or physically disabled (defined as being able to claim the disability tax credit).