Life Insurance Trusts- Introduction, Concept, Advantages, and Disadvantages

Life Insurance Trust: 

Life insurance trusts hold a life insurance policy within them and are designated to manage the policyholder’s life insurance policy. Life insurance policyholders can establish a trust and link their existing life insurance policy to it or take a new one and link it with the trust. The premiums are to be paid regularly like any other life insurance policy, but the power to manage the policy rests with the trust. The trust could be composed of individuals appointed by the policyholder or the honourable court.

Trustee members could be any family members, friends or legal professionals and are entitled to manage the life insurance trust until the trust pays the claim benefits to the designated nominees. The payment in a life insurance trust can either happen after the policyholder’s death or after attaining 18 years of age by the policyholder. Child life insurance plans can also be placed in a trust so that the maturity benefit would be given to the child after 18 years of age or the age specified in the policy document.

Life insurance trusts are created to safeguard the life insurance policy claim proceedings. Here are the different types of trusts which can be selected based on your requirements:-

Different types of Life Insurance Trusts

Discretionary Trusts:

The discretionary trust is the most common trust created by insured policyholders. The insured policyholder has the right to dictate the terms and conditions of the claim proceedings. For this trust, the insured has to submit a letter that guides the trustees in handling the claim proceedings from the life insurance policy. Discretionary trust provides the policyholder with an option to change the beneficiary at any point in time. Here, the trustees have the discretionary power to interpret the terms and conditions of the trust and allocate the claim proceedings accordingly.

Flexible trust:

Flexible life insurance trust is similar to discretionary trust but has extra features. In flexible trusts, the insured policyholders have the highest discretion about the payment of the claim in case of their death; policyholders can even mention how much should be given to whom and when it should be given.

In flexible trusts, there can be more than 1 beneficiary, and you can choose how the money would be split between them. Flexible trusts have a default beneficiary and a discretionary beneficiary. The default beneficiary is the one named by the policyholder, whereas the trust can set up the discretionary beneficiary, and in case of no appointed discretionary beneficiary, all the claim proceedings would be given to the default beneficiary.

Joint life survivor discretionary trust:

All the above trusts are designed for a single individual in a life insurance policy. However, there would be joint life survivor life insurance plans in which both the husband and wife would be insured under a single policy, and in such cases, the above types of trusts may not be suitable. To overcome this issue, joint life survivor discretionary trusts have been in force in which couples with a joint life insurance policy can place their policy in a life insurance trust.

In joint life survivor discretionary trust, there could be more than one beneficiary. For example, a spouse would be the default beneficiary, and children may be the discretionary beneficiary. In case of the death of any of the partners, the other partner would get claim proceedings before the other beneficiaries mentioned in the trust. So, the default beneficiary would get the claim proceedings first, and then the discretionary beneficiary would get the claim amount. In case of the surviving partner’s death within 30 days of the other partner’s death, the trust can pay the claim proceedings to the other beneficiaries mentioned in the trust.

Absolute trust :

Life insurance trust in which the beneficiaries are named and cannot be changed even by the insured policyholder. Absolute trusts are those in which the policyholder would have no say once the trust is created and further changes to the nominee or the terms and conditions of the trust would not be permitted even for the insured policyholder. Absolute trust should be created only after deciding everything, as the insured could not amend any of the details at a later stage.

This is particularly useful when the insured is no longer alive and wants their family members to avail of the life insurance policy benefits. Under this trust, future changes would not be permitted at any cost once the names are given. In case of the nominee’s death, the proceedings would be given to the nominee’s family members. Insured policyholders should take a new life insurance policy and create a new trust if they want to add a new member, as the absolute trust would not permit new additions.

Split trust:

Life insurance policies can sometimes come with add-ons or be linked to another policy, such as a critical illness or personal accident policy. Technically, these policies are different, but since they are bundled together under the trust, taking only one out might not be possible under absolute trusts. To overcome this issue, policyholders can create a split trust in which the critical illness cover or the personal accident cover could be utilised, whereas the life insurance policy remains with the trust.

Split trust provides the flexibility to use the other policies included with the life insurance policy, such as a critical illness policy or a personal accident policy. For example, Mr Naresh has taken a critical illness and life insurance policy and placed them in the split trust. After a few years, he was diagnosed with cancer and required to make a claim under the critical illness policy, which would be permitted under the split trust as the claim proceedings would be utilised by the insured policyholder.

Advantages of life insurance trusts:

Fund utilization as per your wish:

The major advantage of a life insurance trust is that the policy would be locked in a trust, and the utilisation of claim proceeds could be pre-decided by the insured policyholder. In this way, the policyholder would control the spending of the claim proceedings. The policyholder may even note that the claim proceedings are invested to generate returns that could be passed on to the beneficiaries. This is useful for people who fear utilising their life insurance claim proceedings.

The main advantage is that the trustees of the policy would own the policy, keep it safe, and execute the policyholder’s will in case of the policyholder’s death. The trustees would be paid a certain fee to act as the trustees of your life insurance policy. Life insurance trusts would also be beneficial when your children are under 18, or your spouse might need to be able to handle the claim proceedings. Another advantage of life insurance trusts is that they might increase the speed of claim settlement as the trust would not go through the probate. Probate is the legal process to decide if a person’s will has been made correctly and the information provided is accurate.

Avoid tax burden:

Life insurance trusts could reduce the tax burden by lowering the inheritance tax. When you expire, the claim proceedings from your life insurance are taken into account by the tax authorities while calculating the value of your estate. In India, life insurance claim proceedings are not taxed, but this is not the case in other countries where the claims from a life insurance policy are treated as gains and taxed accordingly.

If there is a life insurance trust, it would help in reducing the tax by exempting the claim proceedings from the taxable income. Money from the life insurance policy would not be treated as the estate value and, therefore, plays an important role in reducing the income tax payable by the beneficiaries.

Disadvantages of life insurance trusts:

Losing Access/ Rights:

Life insurance trusts such as absolute trust would remove the policyholder’s rights. In the case of an absolute life insurance trust, policyholders would no longer be able to edit or amend the trust once it is created. If the beneficiaries fall out with the policyholder, the policyholder would not be able to withdraw the benefits provided by the life insurance trust in case of the policyholder’s death.

For example, assume you have taken an absolute life insurance trust and made your spouse the beneficiary. In future, if you were to part ways, you would not be able to change the existing life insurance trust, and the benefits would be payable to the beneficiary.

Irrevocability:

Life insurance trusts are also irrevocable, which means that once you have created a trust, you cannot pull your life insurance policy out of the trust. This means that the life insurance policy would be in the trust forever.

The irrevocability of a life insurance trust only lets you make amendments to it occasionally, and you are also bound to lose control over the trust. The other disadvantage of the life insurance trust is that it may come with higher fees as the trustees may charge high fees to maintain or set up the trust, thereby reducing its net benefits.

Married Women’s Property Act in India: 

Life insurance trusts are common in Western countries but less famous in India. On the other hand, India has a concept similar to that of a life insurance trust but aimed particularly at the wife of the policyholder. In India, when people are in a joint family, there could be instances when the family members deprive the woman of the benefits of the life insurance policy in the event of the death of the husband, who is also the policyholder. To overcome this issue, India passed the Married Women’s Act 1874, which protects the assets named under this act from repayment of debts. When taking out a life insurance policy, you can attach it under the MWP Act, making it shatterproof.

Any life insurance policy attached to the MWP Act will ensure that the claim proceedings from the policy will only be given to the nominee or beneficiary of the policyholder. It also ensures that the claim proceedings would not be paid first to the debtors. This way, the MWP acts as the life insurance trust by protecting the interests of the women. The MWP with life insurance attached to it would be considered a trust, and only the trustees would have the power to control the policy, including servicing and receipt of the benefit amount.

For example, let us assume that you are a salaried person and have taken a life insurance policy and attached it to MWP. You have also taken a home loan and are making regular EMI payments. One bad day, if you expire suddenly, then the bank will come to your family for loan repayment. If the life insurance policy is not attached to the MWP, then the claim proceedings would be given to the bank first, and any remaining amount would be given to the family members. Since you had taken a life insurance policy and attached it to the MWP, the claim amount would be paid to your wife and children, and the banks cannot claim anything from this.

FAQ:

For more information on life insurance trusts, please book a call with our life insurance experts at Ethika insurance broking.