Combining Life Insurance With Trusts for Family Financial Security

Introduction to Financial Risk Management

Financial risk management is an important concept in personal and family finance. A person with an established business, occupation, or source of income can suddenly fall ill, resulting in the loss of income that others depend on to survive. This can be a serious hardship for the individual and for those who rely on that income.

There are two financial instruments that can continue to provide financial compensation or income to the individual or his dependents based on prior investments. For monetary investments made at regular intervals, there is life insurance. For owned property, there is the instrument of trusteeship (Trusts & Trustees, 2003).

Both an established financial fund and property can therefore be managed in the event of the illness or death of the owner. Liquidity is particularly important at the time of death in order to cover final payments and other expenses. This paper reviews different aspects of trusts, life insurance, and their combinations as tools for family financial security.

A trust is established when assets are transferred from one person to another with instructions that those assets are to benefit a third party. The concept of a trust has its roots in English Common Law, and many other countries have incorporated their own notions of trust into their legal systems.

A trust is among the most flexible forms of financial instrument. When an individual places an asset or property into trust, they generally cease to have any further personal interest in those assets. The benefit passes on to the beneficiaries or is held on their behalf.

What Is a Trust?

To ensure that liquid savings are well invested, an individual typically looks to life insurance — which can offer tax advantages and strong growth potential. For property, a trust is often more appropriate, since liquidating property could trigger taxes, diminished values, and other considerations that yield lower returns (Trusts & Trustees, 2003).

Trustor. The trustor is the person who sets up the trust and contributes the original property. In family situations, this is typically the person who may be ill, deceased, or otherwise absent.

Trustee. The trustee is the financial institution or individual upon whom trust is placed. Trustees hold property on behalf of the beneficiary after taking possession from the trustor. The word fiduciary is used to describe the trustee's duties to the beneficiary. The trustee charges administrative costs from the income or proceeds generated by the property, and the remainder goes to the beneficiary.

Corpus. Corpus is Latin for "body." In trust law, it refers to the body of assets — the principal — held in the trust.

Beneficiaries. The beneficiaries are those individuals entitled to receive the income or rewards from the management of the trust property. The trust is created by the trustor for their benefit, and a beneficiary may also be referred to as the donee.

Written trust document. The written trust document is the agreement made between the trustee and the trustor (or settlor). It contains clauses required by government regulation as well as any additional terms and conditions agreed upon by both parties.

Many considerations enter into the selection of a trustee, including what is expected of the trustee, what kind of trust administration is required, and where the property is located. The person setting up the trust should examine their own motives and evaluate the alternatives available — weighing factors such as management fees, taxation, and the terms and conditions of different arrangements. Once a trust is established, the trustor loses direct control over the property. Many trust companies offer banking and other financial institution services as part of their firm (Trusts & Trustees, 2003).

Trusts are created to accomplish specific goals, such as protecting a family in the event of death, providing for the education of a young child orphaned by the death of a guardian, or supporting a cause over time. Some trusts are established for defined purposes such as funding medical research or preserving historical buildings. Such a trust will collect suitable assets, build capital, and then deploy that capital toward its stated objectives — for example, funding university research or acquiring and renovating historic properties (Trusts & Trustees, 2003).

Types of Trusts and Taxation

There are many ways in which trust agreements can be structured, giving rise to numerous trust types. Broadly, however, there are several main categories.

Simple trust. In a simple trust, the income generated — less the management fee — is passed on to the beneficiary. There is no accumulation of wealth within the trust itself.

Complex trust. A complex trust is permitted to accumulate capital and may have a charitable beneficiary or distribute principal to beneficiaries.

Grantor trust. In a grantor trust arrangement, the grantor retains sufficient power or control over the trust that, for income tax purposes, the grantor is considered the owner of the property.

The taxation applicable to each of these forms is determined by the income generated, any expenditures, management fees, property maintenance costs, and the nature of the trust's ownership. If the beneficiaries are charitable organizations, the applicable tax rate will differ accordingly (Trusts & Trustees, 2003).

Inter-vivos trusts are established during the trustor's lifetime, and the property may be transferred to the trustee at a mutually agreed time before the trustor's death. Inter-vivos trusts may be either revocable or irrevocable. A revocable trust can be canceled while the trustor is still alive; an irrevocable trust cannot be revoked once it has been executed.

Testamentary trusts take effect upon the death of the trustor. For example, a person may wish to make a donation to a charity but lack the means to do so during his lifetime. He can arrange for the remainder of his property to be contributed to the charity through a trust that activates upon his death (Trusts & Trustees, 2003).

Irrevocable testamentary trust. An irrevocable testamentary trust cannot be revoked after the death of the person who established it through his will. Limited exceptions may exist and can be determined by a court of law.

Charitable testamentary trust. A charitable trust is one in which the beneficiary is a charitable body — such as an organization advancing the arts, education, or humanitarian causes. It may be either revocable or irrevocable, and its taxation treatment and management fees will differ from those of other trust types.

In a remainder trust, the property held in trust may provide a fixed return to the trustor during his lifetime, or a fixed income to the beneficiary for a specified period or for the beneficiary's lifetime. Upon the death of the trustor or the beneficiary, the remainder of the trust may be directed in various ways — including a charitable contribution. Alternatively, the remainder may be passed to a third individual or organization rather than a charity.

In a lead trust, the property transferred to the trustee is managed, and a percentage of the returns is paid to one beneficiary for a specified number of years. After that period, the remainder of the property is handed over to the heirs or to another beneficiary named in the will. A charitable lead trust therefore pays a percentage of the income generated over a defined period, with the remainder ultimately distributed to the heirs.

Unit trusts invest in a wide variety of shares, making them an excellent investment choice for both new and experienced investors. When an investor purchases a unit, they subscribe to a portion of the total issued shares. The investment manager then attempts to deploy the capital across investment units that offer the highest value relative to the total fund. Running costs — including the costs of buying and selling shares — are charged to the investor in addition to an initial deposit fee. This fee represents a percentage of the investor's share of the total fund. In the United States, this percentage charge is typically debited from a checking or savings account, and as a result the investment may remain tax-free (Unit Trust Center, 2003).

Life insurance, although similar to a trust in some respects, has many distinct characteristics. Most notably, the investment in a life insurance arrangement rests on the life of the investor. There are a multitude of life insurance trust structures available, which is perhaps why they are preferred by many investors. These include term insurance, universal life insurance, whole-of-life insurance, split-dollar arrangements, and others. An investor can choose a combination of these or customize a plan according to personal needs and the amount they are willing to invest.

For example, split-dollar insurance allows a portion of the cost to be paid by a business entity while the investor pays the remainder. The reason a business would participate in such an arrangement is that it allows the company to protect funds on a tax-free basis, as the expense falls under the category of employee insurance. This shared portion may earn premiums that benefit the business as well. The beneficiary can thus obtain insurance coverage by paying only a portion of the total premium while still enjoying long-term benefits.

The insurance trust also allows the investor flexibility to buy or sell whenever they choose to discontinue funding. Many employees, however, favor the irrevocable life insurance trust because it provides lifetime insurance coverage with minimal personal investment — the corporation covers the remainder. Additionally, the proceeds from the trust can be used to purchase property and estates on a tax-free basis, since trust income is not subject to income tax. These features make the life insurance trust particularly attractive to investors (CFFP, 2003).

Another important benefit is that upon the death of a spouse, the trust assets can pass to designated beneficiaries — such as children or individuals nominated by the beneficiary during his or her lifetime — while the value of the trust itself remains intact. Proceeds can then be distributed or reinvested. This approach can further increase the overall value of the trust for the ultimate beneficiary (CFFP, 2003).

Key advantages of this type of trust include:

Conclusion

Ernst & Young. (2003). Avoid abusive trusts. Retrieved November 20, 2003, from

Unit Trust Center. (2003). Unit funds. Retrieved November 18, 2003, from