What Is a Life Insurance Trust?

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A trust can help you secure your loved ones' future.

A trust is a legal entity with a fiduciary relationship in which you (the grantor) give the trustee the right to hold title to assets for the benefit of your beneficiaries. You can fund a trust in a number of ways, including a life insurance policy. 

If you have dependents, setting up a life insurance trust can help you ensure your loved ones will be provided for, even after you’re no longer there to take care of them. 

What are life insurance trusts?

A trust is a financial tool of having a third-party, called the trustee, protect and manage your assets for the benefit of one or more beneficiaries. A life insurance trust is a type of trust that holds a life insurance policy. 

Once you establish a life insurance trust, the latter will own the policy — not you. Upon your death, the trustee distributes the proceeds of the policy to the designated beneficiaries as per the terms of the trust document. 

Three parties are involved in every trust. 

• Grantor: This is the person who funds the trust. If you are establishing a life insurance trust by transferring the ownership of your policy to the trust, that would be you. 
• Trustee: The individual who holds and manages the assets owned by the trust before eventually distributing them to the beneficiaries. 
• Beneficiary: The individual for whose benefit the trust has been set up. 

You might be wondering: Why would someone need a life insurance trust? After all, if a person wants to leave the insurance money to someone, they can simply name that individual as the beneficiary on the policy itself? Why go through the hassle of creating a trust? 

Establishing a life insurance trust gives you additional flexibility in regard to the distribution of the proceeds which you otherwise wouldn’t have. 

Let’s say you own a life insurance policy and have named your three grandchildren — Sarah, Annie, and Martha — as the beneficiaries. However, you don’t want them to receive their entire share all at once when you pass.

Instead, you would like them to receive a specific amount upon reaching each of these life milestones: attaining adulthood, entering college, getting married, and buying their first home. So you establish a life insurance trust, name a trusted person as the trustee, and create a trust document outlining your wishes. 

Although any type of life insurance policy can be used for setting up a life insurance trust, most insurance experts recommend using only whole life insurance. That’s because whole life plans don’t have an end date and provide level death benefits. 

Creating a trust with a term life plan can be problematic since term life insurance only lasts for a set period. Once the policy term ends, there will nothing within the trust to distribute to the beneficiaries. 

With universal life insurance, the problem is of a different kind. While a universal life policy lasts your entire lifetime, it might not provide a fixed death benefit. A fluctuating death benefit, in turn, could potentially leave the trust underfunded. 

Many people view trusts as financial tools designed for people who are wealthy or have complex estates, but that is not so. Even if you are not rich, you can benefit from funding a trust, especially if you want to control your beneficiary’s access to the insurance proceeds.  

How do life insurance trusts work?

A life insurance trust is a trust funded by the life insurance proceeds. The policyholder either sets up an insurance trust and uses it to buy a life insurance policy or gifts an existing policy to a trust. 

The policyholder is the trust’s grantor and chooses a trustee and decides the terms of the trust. Upon insured’s death, the benefit amount is distributed according to the terms of the trust. 

If the trust is a revocable one, the grantor has the freedom to amend its terms or even terminate the trust. An irrevocable trust, in contrast, doesn’t offer such flexibility. 

What are the different types of trusts?

Trusts used for estate planning are either revocable or irrevocable. In both cases, the trust is the sole owner of the assets placed within it, which are eventually distributed to the beneficiaries as per the trust document upon grantor’s death. Nonetheless, each has some distinct characteristics. 

Which one of them will be right for you largely depends on your reasons for setting up a trust. For example, someone who wants to reduce their estate’s tax liabilities may want to go for an irrevocable trust. 

Revocable Trust

A revocable trust is a type of trust whose provisions can be changed or which can be revoked later should the need arise. In other words, as a grantor of the trust, you are in total control even though the trust owns the assets.  

People typically set up revocable trusts to control the distribution of assets to a special-needs child, minor child, or a young adult. For instance, if you are worried that your child is not financially mature despite being an adult, you may set up a trust so that she receives the inheritance in installments rather than at one go. 

A revocable trust can also be a good fit for parents with a special-needs child. This way you can pass a sizable sum to your loved one without impacting their eligibility for government benefits, such as Medicaid. 

Keep in mind that a revocable trust is included in your estate and as such will not reduce your estate’s tax liability. 

Irrevocable Trust 

Once created, an irrevocable trust can neither be modified nor cancelled. As a grantor, you will lose access to your policy’s cash value, assuming you are putting a permanent life plan into the trust. 

However, the loss of control over the assets placed in an irrevocable trust is not without a few upsides. For one, your estate’s tax liability is reduced, since these assets are now owned by the trust, not you. Secondly, the assets within your trust are completely protected from creditors. 

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What are the advantages and disadvantages of life insurance trusts?

A life insurance trust allows you to control how the death benefit is distributed, but it is not for everyone. Knowing the pros and cons can help you determine if you should go down that road. 

Pros

• Greater control over how the insurance proceeds are distributed after your death
• Allows you to name a minor as beneficiary 
• Allows a special-needs child to benefit from the payout without impacting their eligibility for state-sponsored benefit programs
• Protect the insurance proceeds from creditors, probate fees and estate taxes

Cons

• Creating a trust is a complex and expensive process
• Demands extra planning for naming of a trustee and determining the terms of the trust

What are the tax implications of trusts?

Even though the life insurance payout is not subject to taxation, it will be included in your taxable estate. If your estate is large enough, a large chunk of the payout may be lost to tax. You can prevent this from happening by buying a policy using an irrevocable life insurance trust or gifting an existing policy to a trust. 

How do I set up a life insurance trust?

Generally speaking, you will need to complete the following steps to create a life insurance trust. 

1. Decide the type of trust you want

You can set up a revocable or an irrevocable trust. Your estate planning goals and financial situation will determine which one of them is a right fit for you. For example, if you have a large estate and want to minimize estate taxes, an irrevocable trust may suit you better. 

2. Create a trust document

A trust cannot exist with a trust document, a legal document that designates the grantor, trustee, beneficiary, and trust property. It also includes legally-binding instructions regarding how and when the assets held by the trust will be distributed among the beneficiaries. 

3. Determine the amount of coverage you need

The amount of life insurance you need will depend on your personal and financial situation. For instance, someone with four young kids and a large mortgage will likely need more life insurance than a person who wants to set up a life insurance trust for the benefit of his or her spouse. 

Consider speaking with a Dundas Life financial advisor to find out the amount of protection your family needs. Alternately, you can use the DIME method. It quantifies your life insurance needs by taking into account your debts, annual income, mortgage balance, and education costs. 

4. Choose the right type of life insurance plan

A whole life insurance is typically the best option for funding a trust since it doesn’t expire, has a level death benefit, and promises a set return rate on the cash value. But if cost is an issue, a term life plan can be considered. The problem with funding a trust with a term life policy is that you could outlive the policy’s term, and renewing the coverage can be prohibitively expensive. 

5. Buy a life insurance policy

Whether you decide in favour of a permanent or term life plan, don’t forget to shop around. Premium rates for similar levels of coverage can vary wildly among insurance companies, so comparing quotes is the only way to ensure you are getting the best value for money. 

6. Transfer the ownership to the trust

The last step is to transfer the ownership of your policy to the trust. You probably will need help of an estate lawyer to ensure your trust agreement is airtight and meets all legal requirements. 

Once the ownership has been transferred, the trust will be responsible for paying premiums, managing the policy, filing the claim, and distributing the death benefit.

Again, when setting up a trust we recommend getting the help of an expert. Reach out to a Dundas Life licensed advisor today to see if a trust is right for you.

Frequently Asked Questions

How can you terminate an irrevocable life insurance trust?

As a grantor, you cannot revoke an irrevocable life insurance trust on your own. All the same, in certain situations the trustee can obtain a court order to terminate the trust. For instance, the court may agree to dissolve an irrevocable life insurance trust if it can no longer serve its purpose on account of changes in the family. 

Should I put my life insurance policy inside a trust? 

For most people, putting a life insurance policy in a trust is not necessary. However, if you have a large estate, a life insurance trust could prove to be a vital part in estate planning. You may also consider a life insurance trust if your beneficiary is a minor or disabled. 

While a minor can be named as a beneficiary, the law prevents insurers from directly paying money to someone who has not yet reached the age of majority. Therefore, it is better to place the life insurance policy inside a trust managed by someone you trust. The trust will hold on to the insurance proceeds until your child turns 18. 

In the case of a disabled beneficiary, a trust allows the beneficiary to receive the payout without affecting their eligibility for public benefits.