An insurance trust is a tool that can allow a policy owner to control the timing and use of insurance proceeds following the death of the life insured. While commonly used for situations involving minor beneficiaries, using insurance proceeds to fund a testamentary trust can also be effective in many other situations. There are three methods by which an insurance trust can be created.
1. Separate trust agreement
This method has the advantage of being a document that stands on its own. It identifies the trustees, beneficiaries and the terms of the insurance trust. Its complexity should meet the objectives of the settlor and the needs of the beneficiaries and may include provisions such as:
- Broad discretionary or specific powers provided to the trustee
- The ability to make a broader range of investments
- A staged distribution based on age or some other requirement
Care must be taken to ensure that while a separate trust agreement is executed, no property passes to the insurance trust until the receipt of the insurance proceeds when the settlor dies. Otherwise, an inter vivos trust may be created with the disadvantage that income retained in the trust is taxable at the highest marginal tax rate.
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2. Insurance trust clause within a will
A person’s will may also contain specific clauses that direct the insurance proceeds to a newly formed insurance trust. The distribution of insurance proceeds could mirror the original distribution of the will or set out an entirely different distribution.
Caution should be exercised where the insurance trust mirrors the distribution in the will (i.e. the same beneficiaries) because CRA may amalgamate the trusts and thus reduce access to lower tax rates.
To ensure the proceeds do not flow through the estate, the terms of the insurance trust as well as the purpose of the insurance trust should be clearly set out within the will. In addition, the trustee should be specifically referred to in the creation of the insurance trust as opposed to simply relying upon the designation of the executor/trustee in the general wording of the will.
3. Beneficiary designation
This method makes reference to the will but actually creates a beneficiary designation in the insurance application. The beneficiary designation refers to and uses the same distribution as the residue distribution found in the will. The insurance carrier should receive a copy of the executed will.
Planning opportunities and obstacles
If properly drafted, probate may be avoided as the insurance proceeds will pass outside of the estate. This is particularly important in provinces with high probate fees. For example, after the first $50,000 of estate value the probate fees are 1.5% in Ontario and 1.4% in British Columbia.