When preparing an estate plan, clients are sometimes surprised to learn it is not as easy as giving instructions along the lines of “everything to my spouse then our children.” More often than not, these type of instructions need to be broken down much further.
First, we need to talk about the specific assets that comprise “everything.” If this includes life insurance proceeds (the “Proceeds”), we need to consider how this will be dealt with on the policy itself [i.e. how the beneficiary designations are filled out on the forms provided by your life insurance provider (the “Policy Provider”)] and/or in the Will, as the case may be.
Second, we need to consider the ages and circumstances of the beneficiaries you are naming.
If the primary beneficiary is a spouse or other person that you would want to receive the Proceeds outright (i.e. no special provisions needed as to when they can receive the proceeds) then that person can be designated as primary beneficiary on the policy. If you do want to include any special provisions as to when your primary beneficiary can receive the Proceeds (think: spendthrift concerns that the primary beneficiary may spend the proceeds irresponsibly), then you will need to consider the options discussed below.
If the person or people you would name as alternate beneficiary or beneficiaries of your life insurance policy can also receive the policy proceeds outright, then that person or those people can simply be named as alternate beneficiary or beneficiaries on the policy itself. If, however, you want to name a minor child as alternate beneficiary, or a child that is over 18 that you would not want to receive the Proceeds outright, you should consider the various options set our below and the implications of each option.
Option 1: Name your Estate as Beneficiary/Alternate Beneficiary
If you do not want to leave the Proceeds outright to a beneficiary or alternate beneficiary, but alternatively, want the Proceeds to be dealt with according to any trust terms set out in your Will, you can name your Estate as beneficiary or alternate beneficiary of the policy. The disadvantage of this approach is that the Proceeds will be subject to estate administration tax (also known as “probate tax”), which is generally 1.5%. Comparably, when you name a beneficiary on the policy itself, the Proceeds are not considered part of your Estate and are not subject to probate tax. However, the benefit of ensuring that the Proceeds are held in trust pursuant to the terms of your Will may outweigh the amount of probate tax payable on the Proceeds.
Option 2: Insurance Trust
If the probate tax would be significant and you want to make efforts to avoid this, but nevertheless want to make sure the proceeds are not paid to a beneficiary outright, your lawyer could prepare an insurance trust for you. An insurance trust can form part of your Will or be a separate document outside of your Will. Putting the Proceeds in an insurance trust will allow the funds to avoid probate tax. This approach does require additional upfront work for your lawyer though, meaning additional fees. In addition to more drafting, this work may include corresponding with your Policy Provider to confirm the desired language for the designation on the policy. This designation must be worded in a way that the Policy Provider approves of so that there will be no issue with the Policy Provider paying the Proceeds to the trustee of the insurance trust upon your death. While your lawyer can assist you by corresponding with the Policy Provider and informing you of how your beneficiary designation must be worded to work together with the insurance trust, the onus is on you to make sure this beneficiary designation is properly completed with your Policy Provider, who will only make this change with your authorization and direction. Signing an insurance trust but failing to make the corresponding change to your policy will undo the effectiveness of this approach.
It is notable that privacy and creditor protection concerns may also influence the decision of whether an insurance trust is right for you.
Option 3: Multiple Wills
You may be able to avoid probate tax on the Policy Proceeds without using a life insurance trust by having both a Primary and Secondary Will, and naming the trustee of your Secondary Estate as beneficiary or alternate beneficiary of your life insurance policy. If you would otherwise only have one Will this approach will involve more upfront costs. Additionally, the same work mentioned in option 2 above regarding making sure the beneficiary designation of your policy is correctly worded will be required. There is also a risk that your particular Policy Provider will not recognize this designation and force your estate trustee to obtain probate before releasing the proceeds.
With life insurance (like all other aspects of your estate plan), avoiding probate tax should not be the main concern. It may be the case that depending on the situation of the beneficiary or alternate beneficiary you have named, that the proceeds will enjoy better income tax treatment (which is a separate issue from probate tax) as part of the Estate than they would in an insurance trust. This is because an Estate may enjoy graduated tax rates for up to 36 months from the deceased’s date of death. However, these graduated tax rates are not available to insurance trusts.
Ultimately, deciding which of the above options is right for you will require consideration of a number of factors that you will need to discuss with your lawyer (and in light of the above-mentioned tax considerations, potentially your accountant also).
If you would like to further discuss these options and their implications based on your particular circumstances, please reach out to us at Mills & Mills by emailing us or calling 416-863-0125.