Have you ever had a financial/insurance advisor recommend using life insurance to save on taxes? Or you may have never heard of this option. Many people do not understand how this type of tax shelter works.
While many are familiar with how Term Life Insurance may work, there is a different type of insurance that not everyone may be familiar with. This type of insurance is called Cash Value Life Insurance, otherwise known as Universal Life Insurance or Whole Life Insurance. These types of policies include an investment component, otherwise known as cash value.
Those who purchase this type of coverage, typically don’t need the insurance. They have more than enough already, and either way, their kids are going to be fine financially. However, they choose to incorporate insurance as a part of their estate planning, as a tool to help reduce tax to enhance their estate. The insurance will fund the tax bill that comes due once RRSP’s and other investments are deemed disposed of upon last death. It can be used to pay for known capital gains, such as a cottage or investment properties. For these types of individuals, insurance isn’t a cost – it’s an investment. They are shifting money from one asset class to another and can use the coverage as a tool to help make planning easier.
How does the tax break work?
- A Cash Value Life Insurance policy provides Tax Exempt Growth (No annual accrual taxation)within the insurance policy. Your alternative non-registered investments are typically taxed annually on the interest you earn. The tax rate would depend on the type of investment. Typically, insurance is an alternative to other conservative investments such as bonds which are taxed at your marginal tax rate (53.53% in Ontario). We all want/need some level of “safe” money to help stabilize a portfolio, especially as we age. Unfortunately, this type of investment is typically taxed in the least efficient way.
- An insurance policy provides Tax Free Insurance Proceeds at Death.This bypasses probate and is paid directly to your beneficiary. This also can get the money into the hands of your loved ones quicker, as larger estates can be complex at times. Other assets are taxed at capital gains rates (26.76%) or full income inclusion (ie. RRIF 53.53%).
- If you need access to the cash value of your life insurance policy while living, one will typically use leverage (borrow against the cash value of the policy) to avoid taxation. Certain life insurance policies (Whole Life as an example) guarantee that the cash value and death benefit will never decrease. Those types of policies are viewed more favourably by lenders, and often one can borrow between 75% – 90% of their cash value via a third party loan. This may be helpful in circumstances when the equity market is down, and you don’t want to withdraw other investments given the current losses. You may decide to borrow against the life insurance and pay back that loan once the markets recover.
- If the policy is being held corporately, then the proceeds will be paid out directly to the corporation at time of death (if properly structured). The corporation will also receive a credit to the Capital Dividend Account (CDA) which will allow the surviving shareholders to withdraw most of that death benefit out of the corporation on a tax-free basis. Alternatively, without insurance, the surviving shareholders would need to pay tax on the taxable dividend when taking money out of the corporation. Insurance can help get surplus assets out of a corporation in a tax-preferred manner.
What you will want to look at is the Equivalent Rate of Return. This is the rate of return you will need to earn in a taxable environment to match the death benefit of your policy. This can help you determine if the policy makes sense, or if you are simply better off to invest elsewhere. Typically, one would want to set this up a joint-last-to-die policy (if they are married) to maximize the death benefit.
An individual considering this type of tax shelter would also want to have firstly maxed out their TFSA. If someone told you that you could contribute more into your TFSA, you would most definitely do it for the tax-advantages. That is what you are trying to mimic with an insurance policy, it’s a vehicle that allows tax-free accumulation and tax-free distribution upon death. The big difference is that the insurance really isn’t for you, it’s designed with your loved ones in mind.
Some cash-value life insurance policies can be very complex, and due diligence is crucial. Your accountant may want to be involved as well, especially if this is going to be held corporately. This type of planning typically works best when the insurance specialist, accountant and financial planner are working together to create a plan for you.
Everyone knows that there are only two things certain in life, death and taxes. Insurance can help you take advantage of your eventual death to reduce your tax liabilities, allowing you to create a larger legacy for your loved one.