Saturday, August 04, 2007

Life Insurance Trusts for Your Spouse and Children

I like preparing life insurance declarations for couples with young children.

I have written before about some of the advantages of having a lawyer prepare an insurance declaration that sets out trusts for minor or young adult beneficiaries, instead of relying on the insurance company designation forms. On the insurance company forms, you can name one or more primary beneficiaries, and alternates, but the forms don't provide for more sophisticated planning. For example, it would be difficult to defer the age at which a child gets full control of the life insurance proceeds to an age later than the age of majority. Do you want your child to have control over hundreds of thousands of dollars at eighteen or nineteen?

It is probably most common for couples to name each other as the beneficiaries, and then provide for the children as alternates (in case the other parent has died first). But, in some cases I have suggested to my clients that they consider something a little different.

Lets use an example. Supposing a husband owns a five hundred thousand dollar term life insurance policy on his own life. (It is important that he is the owner of the policy.) If he designates his wife as the beneficiary, on his death she will receive the proceeds tax free. She will likely need to invest the proceeds to provide some income for her to support herself and any minor children.

When she earns income on the investments she will pay tax on the income. The rate of tax will depend on how much other income she makes. This is because Canadian tax law provides for higher rates of taxation at higher incomes. (You can see the different rates for 2007 courtesy of KPMG here.) This means that if she works outside of the home, she may have to pay a relatively high rate of tax on the income earned from the life insurance.

One alternative is for the husband to sign a declaration in which he appoints his wife as a trustee to hold the proceeds of the life insurance in a trust for the benefit of herself and their children. As trustee she has the responsibility of managing the proceeds on his death. The terms of the trust can allow her to decide to make payments to herself or to one or more of her children. She still has control.

If the husband owned the life insurance policy on his own life, and made the declaration creating a trust arising on his death, the trust will qualify as a testamentary trust as defined in section 108(1) of the Income Tax Act, Canada. Please note that the trust must arise on the husband's death. The trust will be treated as a separate tax payer, taxed at graduated tax rates.

The wife as the trustee can choose to have the income taxed in the trust. If in our example, the insurance proceeds earn income of $25,000 in a year, the rate federal and provincial income tax in British Columbia would be about 21% (it will be different in other provinces.) On the other hand, if she earned the same $25,000 investment income in addition to $50,000 employment income, the rate of tax on that $25,000 would probably be at least 31 %. By having the income taxed in a trust, she saves about $2,500. She can get similar savings every year.

Because her children are also beneficiaries of the life insurance trust, she could pay the income to them, and have the children declare the income on their taxes. If they are students without much other income, they may be able to shelter the income under their personal tax credits. The effect may be in some cases that the income can be earned tax free.

The insurance declaration can also provide that any funds remaining in the trust on the wife's death can go to the children, or into trusts for them. There should also be a trust for the children if the wife dies before the husband.

In our example, the wife might have her own life insurance policy on her life. She can create similar trusts for her husband and children.

I caution that as with all estate planning techniques, there are occasions when this type of trust will not be appropriate, but I think it suites many couples with young children well.

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