When planning to pass considerable wealth to the next generation, life insurance can add certain guarantees to your estate plan.
Life insurance is used as a standard solution to create instant tax-free capital for families and businesses that may otherwise face serious capital shortages if a breadwinner or business owner were to die.
The tax advantage of life insurance
Advanced uses of life insurance include:
• the protection of financial stability in the event of death;
• tax-preferred treatment on large sums of investment growth;
• the creation of large sums of new capital; and
• a tax-free method of transferring wealth from one generation to the next.
Only a few options enable Canadians to defer taxes on investment income: RRSPs, capital investments, equity funds, and Universal Life (UL) and some permanent life insurance policies. UL is a permanent life insurance plan that not only covers you for your lifetime; it also offers tax-deferring potential.
If you have maximized your RRSP, are in a higher tax bracket, and may have a capital gains tax liability in your estate, a Universal Life (UL) insurance policy can help maximize the wealth you transfer to your heirs by allowing you to accumulate interest on a tax-deferred basis.
How is the insurance premium paid while investments grow? A Universal Life insurance policy provides a tax shelter during life, generating investment income while the cost of the insurance can be paid from tax-deferred earnings within the policy. Additionally, a tax-free benefit (which can be designed to have an increasing death benefit) is paid at death, allowing for a significant transfer of assets to the next generation.
Various uses for life insurance
1. Family capital and income provision.
Protecting your family's financial well-being through the period of building wealth is as equally important as understanding how to accumulate wealth. Failure to consider the loss of income as a result of early death (or disability or critical illness) could jeopardize your financial goals.
When we are young, the assets we accumulate are often offset by our debts that secure them. For example, mortgages often equal 60 to 90% of the value of a house. In the event of your death, survivors will require capital to pay off debts, and you may also want to provide an income for your family (and educate children, etc.). Life insurance can provide the capital your dependants will require.
Depending on your financial plan, you may need a quarter- or a half-million dollars to ensure your family's future financial security. By using income splitting of future incomes, the future tax payable can be reduced. If the insured names his or her spouse and individual children as beneficiaries, then taxes payable later (when the beneficiaries invest their individual inheritances and start to receive income from their investments) would be reduced by this income splitting, as their tax rates would tend to be lower than if all of the income were to be taxed in the hands of one person.
Younger children may also have personal exemption room to offset investment income tax attributed to them, thereby further reducing the tax on the overall investment income of the family.
2. Capital gains must be considered for wealth preservation.
If a family business has grown substantially, there may be large capital gains tax to pay if it is sold or transferred to a child. Consider taking out enough life insurance to cover any capital gains taxes due. The insurance proceeds are paid at precisely the time cash is needed for a smooth transition. If you want to keep a business in the family, you can also take out enough life insurance on yourself to equalize your estate, paying a benefit to children who may not be active in the business.
Deemed disposition when passing a cottage to the children. Capital gains tax may also be due if you own real estate other than a principal residence (such as a cottage or rental properties). Whether ownership of such property goes directly to beneficiaries or into a trust, a deemed disposition takes place. This means that if the value has increased, capital gains tax might have to be paid. Your accountant can help you calculate an estimation of what that might be, based on the current fair market value of the property versus what you paid for it. Bear in mind that, currently, only 50% of the capital gains is taxable when disposed of or upon your death (where there is no surviving spouse). However, large capital gains (although only half of which are taxable) can put you in a much higher personal tax bracket in the year the disposition occurs.
3. Wealth transference to future generations using life insurance.
Life insurance allows for tax-preferred treatment of investment growth on large sums of capital being transferred from the deceased to his or her heirs by the creative use of a life insurance policy. Once the first premium is paid, there is the immediate creation of a large sum of new tax-free capital when (later) received by the heirs. Wealth is thereby transferred from one generation to the next upon the death of the insured.
Family business uses of Universal Life include the following:
• Life insurance can create cash to pay off liabilities in a business, such as bank debt or estate taxes, when a business owner dies.
• It can create enough money to fund a buy-sell agreement. This allows business partners to buy a company from the surviving shareholders.
• It can be assigned to secure repayment of an operating loan or as collateral for a new loan or mortgage from a financial institution.
• Succession planning can strategize to create special capital bequests to non-business heirs to equalize the value of business bequests made to children and other heirs (when a business is passed on to one child, where other children would receive less).
• A business's key person who dies or becomes disabled can be replaced using capital from life insurance.
• Life insurance can fund a charitable bequest of the owner's choosing.
• By the use of beneficiary selection, business owners can preplan to create capital security for a spouse and/or children from which to invest and create replacement income to take care of them. This avoids the potential need to drain the company of funds.
• The policy amount is immediately guaranteed upon payment of the first premium.
• Some plans can reduce current taxes on investment income.
• Life insurance can avoid costly probate fees.
• The life insurance capital benefit is creditor proof.
• It simplifies an estate transfer of wealth because it creates immediate new family wealth that can be paid out tax free.
• It minimizes the risk of will contestability.
• The company could take taxable withdrawals from the investment portion of the policy or borrow tax-free cash, collateralized by the value of the investments.
• Guaranteed death benefits as well as cash accumulation in the plan are free of ongoing taxation. Note: Some of the invested monies can be withdrawn tax free in relation to the amount of the adjusted cost base (ACB) of the policy.
How does life insurance get tax-preferred treatment on investment growth? You can invest money as term deposits as part of a Universal Life (UL) policy that allows the ongoing growth of the investments to remain untaxed as long as they are not withdrawn from the policy. The future cost of the insurance (including any related administrative fees) is paid from the pre-taxed cash element accumulating in the policy. Upon the death of the insured, the value of the life insurance face amount plus the tax-deferred growth can be paid out entirely as a tax-free cash benefit to the beneficiaries.
How the tax deferral works. If you earn 5% in a Universal Life policy and you are in a 45% tax bracket, you would need to earn about 9% outside of the plan to match the UL strategy. Over time, the cost of the insurance and policy fees may actually be paid from the accumulated assets within the policy.
Control over investments. The Universal Life plan is flexible because you maintain control of the investment portion of the plan. There are usually several options such as term deposits or segregated funds. When you pay your premium, a portion pays for the insurance component, while another portion goes into an investment linked to the plan. When that investment is held in interest-bearing vehicles, the interest is not taxed until withdrawn from the policy. The objective is to keep the investments growing, from which the future insurance costs can be paid.
You can choose how much money you want to invest in a UL plan—a minimum amount or a substantial amount; in some cases, a few annual payments can secure a lifetime of prepaid coverage. The savings portion is kept separate with the intent to pay the insurance component on into the future. Significant investment room is allowed to facilitate partial or full prepayment of the policy. Then it is possible to pay the insurance component with pre-tax dollars directly from the investments associated with the policy. Money held in the policy's term deposits accrue free of tax and, in some cases, can be withdrawn as tax-free cash. It may be possible to acquire a loan using the tax-deferred cash as collateral. In some advanced planning situations, the bank may allow a portion of or the entire loan to remain on the books, with the intent to redeem the loan via the tax-free death benefit when the policy owner dies (the death benefit is assigned to the bank). In this case, the investments inside the policy continue to achieve tax-deferred growth and can accumulate an increasing tax-free death benefit value.
