Many wealthy families think of Life Insurance as a grudge purchase, much as they think of their car or house insurance. They don’t realize that Life Insurance is about much more than replacing income to support families left behind after a death − a financial challenge seldom faced by families with significant money. With proper planning, it’s a tremendous opportunity to support wealth-building and manage risks that include over-taxation and future taxation increases.
There are two basic types of Life Insurance: term and permanent. Term insurance covers you for a specific number of years. At the end of the term, the policy has no value. Permanent insurance (which includes universal Life Insurance and participating whole Life Insurance) provides a lifetime of protection plus an investment component. It’s an asset with enduring value.
The federal budget and capital gains
Some of the best news contained in the April 2022 federal budget and November 2022 Economic Statement was what they did not mention. There was no increase in the capital gains exclusion rate of 50%, which keeps 50% capital gains tax‑free. There was no introduction of a wealth tax, an inheritance tax, or a principal residence tax (other than ensuring that sales within 1 year cannot normally claim principal-residence, which was already the case in more reported Court cases). Looking ahead, there’s no guarantee that any of those opportunities to build and pass along wealth in a tax-favoured way will remain in place.
One federal budget change removes a tax‑planning opportunity for substantive Canadian-controlled private corporations (CCPCs). People were doing some planning involving entities established in other countries that allowed investment income to be taxed in their corporations at about 26% instead of about 50% (the exact rate varies by province). Basically, they got the general rate of tax rather than the investment income tax rate in a corporation. That was creating some deferral advantages. With the budget, this type of planning was shut down.
This change has the effect of making Life Insurance much more attractive compared to other investments within these CCPCs. Life Insurance now easily outperforms many of the alternatives because it provides tax‑exempt growth and creates the opportunity to recharacterize retained earnings into tax-free capital dividends.
Here are 5 ways that affluent families can use tax-exempt permanent Life Insurance to preserve wealth, grow assets tax-exempt and create enduring legacies, often by converting taxes into charitable giving.
#1: Fund taxes due on death
Without advance planning, assets may be taxed on a deceased person’s terminal return at a rate anywhere from 27% to 70%. The estate must pay that bill from cash on hand (which many successful people don’t have because their cash is effectively deployed), borrowed funds (not attractive because the interest rate adds insult to injury and is not deductible) or by selling assets (a sale should never happen under pressure, and it eliminates future growth potential from those assets).
The better option? Life Insurance. For pennies on the dollar, you can create a tax‑free lump sum that is paid promptly and can cover the terminal tax bill. And for those comfortable with borrowing to invest, using an Immediate Financing Arrangement (IFA) can create a cash flow neutral structure, allowing continued investment in private equity, real estate and securities, rather than tying up funds in insurance premiums.
#2: Avoid double or triple taxation
What we call “post-mortem planning” focuses on eliminating double or triple taxation that can be triggered when a shareholder in a private corporation dies. On death, there could be capital gains tax resulting from the deemed disposition of shares. There can be also corporate tax on the capital gains from selling the corporation’s assets, and a dividend tax when the money is extracted from the corporation and into the hands of heirs.
Those three layers of tax can significantly erode the value of an estate, but two strategies, used individually or together, can help:
- Redemption-loss carry-back – eliminates the capital gains tax and must be completed within one taxation year of the shareholder’s death
- Pipeline – eliminates the dividend tax and can be completed within three to five years of the shareholder’s death
Usually, you will do the redemption-loss carry-back when you have favourable tax attributes such as refundable dividend tax on hand or capital dividend account balances. And often you do a pipeline when you’re in a more favourable capital gains environment, like today. We’ll discuss both strategies in more detail in a future Lax Letter.
Both strategies can use Life Insurance strategically to create a lower effective tax rate.
#3: Make fair bequests
“Equal” isn’t necessarily “fair”. Suppose Mom and Dad start a business, and they have three children. The daughter works in the business and will one day take over the corporation. The two sons work in other professions. It would be “equal” to divide the shares of the corporation among the children with one‑third going to each – but that wouldn’t be “fair” to the daughter, who would suddenly become a minority shareholder with two-thirds of her success in running that business flowing out as dividends to her brothers. It would be much fairer to leave the company to the daughter and provide other assets of equivalent value to the sons.
Estate equalization looks at the estate as a whole, rather than each piece, to ensure bequests are fair to all heirs. It’s an essential consideration when there’s a family business and can also be very useful for blended families. Life Insurance is a straightforward and cost-effective way to achieve estate equalization.
#4: Diversify fixed-income investments
Permanent Life Insurance provides a unique tax-exempt investment opportunity that can contribute to the diversification of a portfolio of other assets. Specifically, high net worth families often reallocate some fixed-income investments into permanent Life Insurance to improve returns with the same or lower volatility.
Permanent Life Insurance policies are very predictable and boring, but they can provide long-term returns equivalent to a pre-tax yield of 9% more. In addition, in a corporate setting, you can pay for these policies with after-tax, corporate dollars, with the death benefit credited to the capital dividend account and then withdrawn from the company virtually tax-free. This is an extremely tax-efficient way to get money out of a corporation to benefit the next generation.
Here is the easiest way to see how this strategy could fit your planning. TFSA balances have now surpassed RRSPs in Canada. Imagine if you could have a NO Limit TFSA for yourself personally or for your corporation. Your money would grow tax-exempt, could be accessed tax-free and could be passed along virtually tax-free. Such a strategy exists. And this is how permanent Life Insurance is used by affluent families in Canada.
#5: Accomplish Strategic Philanthropy
A primary goal for many affluent families is to create a substantial charitable legacy. It’s possible to create a significantly bigger legacy by converting taxes into philanthropy with permanent Life Insurance. There are many ways to do this, but here’s one of the simplest.
Charitable donations can offset up to 75% of net annual taxes payable in any year, and any additional amounts can carry forward for up to five years. But the rules are even more generous when it’s time to file a deceased person’s terminal tax return. At that point, charitable donations can offset up to 100% of the taxes due for the year of death and for the preceding year.
So, if you’re anticipating an income tax hit of $1 million in each of those two years on your death, you could create a tax-efficient $2 million Life Insurance gift. Instead of paying a lot of money to the CRA, you can provide a large donation to support the causes you believe in.
And consider using an IFA to achieve your philanthropic goals. For those who qualify, it’s akin to having your cake and eating it too, which means you can do better for the charities and causes that you are passionate about. But all of this needs to be viewed as part of your overall estate planning.