Putting faith in insurance trusts

Are they the right tool for passing a portion of your wealth to others?

When deciding what you want your estate plan to include, you’ll likely want to identify the most legally efficient and tax-effective approach for your situation. One of the most important components of that plan is the distribution of money and assets to your loved ones after you pass away. A will is one way to do this. A formal trust is another way, which differs in a few important ways and can be a useful part of estate or tax planning. Let’s look at the basics of trusts, with a particular focus on insurance policy trusts.

What is a trust?

In simple terms, a trust is an arrangement for transferring property from one person to another. Think of it as a mechanism that enables one person (a settlor) to provide property to another person (a trustee) for the benefit of a third person (a beneficiary). Many people are familiar with trusts as a common method of holding money and assets for others while imposing restrictions on the use of those assets.

A trust can also help maintain confidentiality. Unlike a will, where details of an estate can become a matter of public record during the probate process, the contents of a trust remain confidential. Although it may not be possible to avoid probate if the estate is complex, or if the will is challenged, using a trust can help protect how much of your estate becomes publicly accessible. Read more about probate here.

There are two types of trust: a testamentary trust, which takes effect upon the death of the owner, and a living (or inter vivos) trust, in which the property of the trust is settled while the settlor is still alive.

Trusts can be established with rules or conditions that can be effective for a specified length of time. Take, for example, a life insurance policy. If the policy owner wants to set a future date for the death benefit proceeds of the policy to be shared with beneficiaries, that timing can be outlined in the trust agreement.

Some people prefer trusts for their versatility. In some cases, they can be used to manage assets outside of an estate in order to achieve tax savings and other benefits (see below).

Creating a trust

A trust must include three main certainties to be valid:

  1. A certainty of intention. The settlor must disclose the intention to create the trust.
  2. A certainty of subject matter. There must be property vested in the trustee.
  3. A certainty of objects. The beneficiaries of the trust (for example, a person’s children) must be identified.

To qualify as a formal trust, the trust document or declaration of trust must identify the settlor, the property, the trustee and the beneficiary (or beneficiaries). An informal trust does not involve a written trust agreement, and as such, its existence, terms and conditions can be difficult to prove. In Quebec, only formal trusts are recognized, as the concept of an informal trust doesn’t exist.

Trusts and taxes

Income in either a testamentary or inter vivos trust is taxed at the top personal marginal rate, which can be higher than 50 per cent in some provinces. In contrast, graduated rate estates and qualified disability trusts are taxed at graduated tax rates. The income that trusts earn must be reported, but a trust may be entitled to deductions for amounts that are paid or made payable to the beneficiary in the same tax year. The beneficiary reports the income received – and given that they might belong in a lower tax bracket than the trust, the total tax burden is lowered by dispersing the funds to the beneficiaries.

It’s important to note that most trusts are irrevocable, which means that the property they outline to be transferred to others can’t be reclaimed by the owner unless it’s specifically noted in the trust. Creating a revocable trust can have tax consequences and is generally not advisable.

Who would need an insurance trust and why?

An insurance trust is created by a policy owner (settlor) to ensure the proceeds of the policy are distributed to the beneficiaries of the trust in a specific, controlled and efficient fashion.

This type of trust is suitable for someone who wants to establish a life insurance policy that is separate from their estate. In addition, they may not want the intended beneficiary to receive the death benefit proceeds directly. This can be the case, for example, with reckless spenders or disabled beneficiaries. Using an insurance trust can ensure the owner’s final wishes are carried out explicitly.

Upon the settlor’s death, the trustee invests the insurance proceeds and administers the trust for one or more beneficiaries until it’s time to distribute the assets as outlined in the agreement. One of the features that people appreciate about trust agreements is being able to determine how the trust property is to be invested and the precise time when that property will reach the beneficiary.

Residents of Quebec should be aware that insurance trusts are not available in the province, as defined under the Quebec Civil Code.

Establishing an insurance trust

Speaking with your advisor is an effectual first step in the process of establishing a trust that addresses the settlor’s needs and wishes. A trust can be set up in a few different ways.

As part of your will. Because the insurance proceeds feed into the trust by way of an insurance declaration, they are separate from the other assets of the estate and are not subject to probate or creditors’ claims. This can apply even when the insurance declaration creating the insurance trust is written in a will.

A trust agreement. Since the insurance declaration that contains the trust is a standalone document, the insurance proceeds won’t flow through the estate and are not subject to probate or creditors’ claims.

Hybrid (using the settlor’s existing will). The hybrid method is the easiest way to create an insurance trust if a valid will exists. When the policy owner completes the beneficiary designation form for the life insurance, they name a trustee and reference the trust created by an existing will. The trustee then follows the provisions of the will to distribute the insurance proceeds. 

Regardless of the chosen method, an experienced estate lawyer should draft the provisions of a trust to ensure the document is legally sound and certified.

A tool among many

An estate plan is a chronicle of your life’s legacy and the roadmap for sharing and advancing your wealth beyond your years. An insurance trust is a viable option for those who want to retain peace of mind while exercising control over how the proceeds of their life insurance policy flow to their beneficiaries. Be sure to speak with an advisor about how trusts might fit into your estate plan and complement the full range of your long-term financial goals.

To learn more about trusts, visit this online estate planning toolkit.