Life Insurance Trusts - What You Need to Know

If you’re a Canadian and people depend on your income to survive, then a life insurance policy will provide them with protection in the event of your death. 

A simple term life insurance policy can be a straightforward way to provide your loved ones with a lump sum of cash (also called a death benefit) they can use to cover the cost of living and other more significant expenses. 

But if you want to control how and when your life insurance proceeds are used, you’ll need to employ another tool. You’ll need a life insurance trust.

What is a Life Insurance Trust?

A life insurance trust is a tool that lets the owner of the life insurance policy control how their life insurance proceeds are distributed and when. Life insurance trusts are most commonly used when the beneficiaries are minors. 

In these cases, trusts are usually administered by trustees. Trustees are third parties that are legally responsible for managing the trust. A trustee will hold your life insurance payout in trust until your children are the age of majority.

Benefits of choosing a life insurance trust

• Beyond giving you greater control over how your death benefit is distributed, a life insurance trust can also be tax-efficient and protect your funds. A properly drafted life insurance trust will help you avoid probate taxes on your death benefit. Probate taxes can be in the range of 1.5%, so depending on the size of your insurance policy, this can amount to thousands of dollars.
• A life insurance trust can also protect your death benefit from creditors. An adequately established life insurance trust will protect your benefit from being lumped in with the rest of your estate, protecting it from the companies to whom you owe money, reserving it for your family first. While a deceased person’s estate is obligated to pay off debts, any outstanding consumer debt (e.g. credit cards, lines of credit, and bank loans) may just disappear. 
• Finally, a life insurance trust is required if you want your children to receive your death benefit. Children under 18 cannot accept control over money from a life insurance policy. Suppose you name your children as beneficiaries without establishing a trust. In that case, your death benefit will be held in trust by a trustee, or your province, and won’t be paid out until the children reach the age of majority in their province.

Types of life insurance trusts

There are several different types of trusts available in Canada, each with its unique purpose.

Separate Trust Agreement

A separate trust agreement is a stand-alone agreement that lays out the trustees, beneficiaries, and the terms of the trust agreement. Separate trust agreements can be very simple or complex, depending on how you’d like your death benefit to be paid out.

Some standard terms that you might find in a separate trust agreement include permission for the trustee to invest the death benefit and how you’d like it distributed (for example, at a certain age or another milestone).

A separate trust agreement must be drafted by a lawyer and is irrevocable after death, which means no one but you can change it. For this reason, think very carefully before creating a separate trust for your life insurance and what instructions you want to include for the distribution of your death benefit.

Insurance trust within a will

An insurance trust in your will is another way of handling the distribution of the death benefit. 

However, creating an insurance trust within your will does not simply mean making your death benefit a part of your estate and distributing it per your wishes. While you can take this route, your death benefit might be subject to an estate administration tax, and creditors could claim the death benefit to pay outstanding debts.

Instead, an insurance trust within your will directs the executor of your will to create an entirely separate insurance trust with a named trustee and administration instructions. This precise wording of the creation of a trust will ensure your death benefit is safe from estate administration taxes and is kept separate from the rest of your estate.

You can create an insurance trust when you create your will for the first time, or you can modify your choice after the fact.

Designate a Beneficiary

To determine how your death benefit is paid out, you can designate a beneficiary right on your policy. This strategy is the easiest way to determine who gets your death benefit, especially if your needs are straightforward. 

For instance, If you plan to have your death benefit payout to a spouse with no limitations on how they spend the money, designating a beneficiary on your life insurance policy is a good strategy.

If you have more complex needs, you can reference the beneficiary designation in your will and indicate that your life insurance policy will have the same distribution. You’ll need to ensure your life insurance company has a copy of the will.

Pros and Cons of Life Insurance Trusts

Setting up a life insurance trust is an excellent way to control your death benefit’s payout. There are, however, some drawbacks. Here are the pros and cons.

Pros

• Greater control over the distribution of your death benefit
• Protection for minors who cannot receive power over the money until 18 years of age
• Protects your death benefit from estate administration taxes, creditors, and probate fees

Cons

• There are extra fees associated with creating a separate trust agreement or an insurance trust within a will
• Requires extra planning for designation of a trustee and terms for distribution of the trust

The bottom line

If you have loved ones that your death would negatively impact, it’s wise to have a life insurance policy that will pay a death benefit if the worst happens. In most cases, designating your spouse as the beneficiary is sufficient to ensure they receive the death benefit promptly. 

That said, if you have wishes about the dispersion of your death benefit and to whom, one of the life insurance trust tools we outlined above could give you the extra control you need, especially if your minor children are involved.

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